Guest post by Axel Merk, Portfolio Manager, Merk Funds

November 30, 2011

Can the euro be saved? Is it possible to stem the flight of money from the periphery into the core? With a botched German auction in mind, investors are now wondering whether it’s possible to prevent a flight out of “all things euro”? We examine the dual challenges of fiscal sustainability and bank solvency in this analysis, with the not-so-modest title “Guide to Save the Euro”.

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Fiscal sustainability

Fiscal sustainability is about revenue and expenses, but also about perception. As the housing bubble in the U.S. proved, what is affordable at low interest rates may become a nightmare when rates go up. Similar rules apply to governments: if there is a perception that obligations won’t be paid back, the cost of borrowing will skyrocket. Spain is the most recent case study. Recent elections kicked out the socialist government, giving an absolute majority to the party of conservative prime minister-elect Mariano Rajoy. You would think that Rajoy would give a speech, declaring how his party will use its mandate to ensure Spain’s obligations will be met, how the rigid Spanish labor market will be opened up, how Spain – with one of the lowest debt to GDP ratios in the developed world – will have a strong comeback. You would expect his team would give an update on how to clean up the Spanish banking system; how his administration will be transparent and give frequent updates on progress. However, in an apparent proof that politicians globally are utterly clueless about all things finance, Rajoy pronounced in an interview that Spain would be unable to come to a sound financial footing if it has to pay 7% on its debt. The market’s response was swift: Spain had to pay 5.1% to sell 3-month Treasury Bills in late November, versus 2.3% just a month earlier. While Rajoy has lined up what some consider extremely competent people, he is not known to make tough decisions. Overlay this with the concern that members of his party are responsible for some of the policies that have led to the current malaise and you can see why the market seriously questions whether there is the determination to make the necessary tough decisions – decisions that will likely step all over the toes of regional decision makers in his own party.

But fear not! The market will bring Rajoy and other policy makers to their knees. By imposing punitive borrowing costs on Spain, the Spanish government will get the message. The question then will be whether the medicine will be too tough to swallow. Regaining market confidence after destroying it is rather difficult. It took former Federal Reserve Chairman Paul Volcker the herculean task of raising interest rates to 20% to convince the market that he was serious about fighting inflation; in contrast, when there is confidence, a Fed official only needs to utter a few words to appease concerns in the market. Similarly, what would have historically been a regular budget battle to balance the books may become a struggle for survival.

To achieve a sustainable budget, the obvious levers are to increase revenue or to cut spending. As Greece has shown, raising revenue through tax increases does not necessarily work; governments can also liberalize their labor market, cutting red tape. They can sell off government property to reduce debt levels, but in the absence of other structural reform, such sales might only be a short-term patch up. The expense side, of course, is where real progress can be made. All governments of developed countries face the risk that they have made too many promises. Some of those commitments can be renegotiated in an orderly fashion, others through default.

Policy makers believe that if there is some magic elixir – such as an insurance scheme or an unlimited Chinese checkbook, governments will have the breathing room to clean themselves up. However, our dear policy makers have proven that the moment the pressure abates, the willingness to push through tough reforms evaporates. That’s not a European trait, but a universal one: in the U.S., there is no pressure applied by the bond market and, as a result, there is no agreement to tackle fiscal sustainability in the U.S.

What about calling it quits, leaving the euro? We have long argued that it isn’t in anyone’s interest to leave the euro. Take Germany: a currency dragged down by weaker peripheral countries helps German exports. Germany is effectively operating with an artificially weak deutschemark. More importantly, if Germany were to leave the euro, money might be sucked out of the financial systems of weaker Eurozone countries and into Germany, thus exacerbating a collapse of the periphery. Just because this isn’t in Germany’s interest, it doesn’t mean the market isn’t pricing it in: in the third quarter, large Italian and Spanish banks reported double-digit percentage declines in deposits from corporate and institutional clients, although their overall deposit levels only dropped by approximately 2%.

Generally speaking, there are two paths that may lead to fiscal sustainability: surrendering sovereign control over the budgeting process; or, embracing the brutal pressures imposed by the bond market.

Surrendering sovereign control over budgeting process

When a government asks the IMF to help, tough austerity measures are imposed, a de facto handover of sovereign control to an outside agency. Keep in mind that the IMF currently does not have sufficient resources to step in and rescue Europe. It would require Europe and the US to swallow their pride and allow China to chip in. China, in turn, would rightfully demand substantial voting rights at the IMF.

When other Eurozone countries impose terms, the process is similar, except that the IMF has more established processes, i.e. is used to playing “bad cop” when it comes to imposing highly unpopular reforms. The same can be said should a fiscal union be introduced that many are calling for: for Germany to agree on any fiscal union in which Eurobonds are issued, stringent rules are likely to be imposed on beneficiaries of the proceeds of such bonds. The fiscal union is already taking shape. The notable shortcoming is a lack of defined process regarding how money will be deployed – unfortunately this shortcoming in the current setup means that each flare-up in the crisis is addressed with yet another patch.

As part of a more formalized fiscal union, Germany may open its checkbook to bail out the rest of Europe. That’s a tall order, but the market is starting to price in that possibility. The recent botched auction where the German Treasury was unable to place all of its 10-year bonds showed that investors are now demanding higher rates of return to lend money to Germany. Just recently, Germany’s 10-year bonds yielded less than 2%; as of this writing, the yield has risen to 2.3%. While still low, it shows that “fiscal integration” in Europe means that a yield conversion won’t happen at Germany’s cost of borrowing level. Germany will also have to get used to the idea that the German bond may have to give up its benchmark status to a Eurobond alternative over time. To the casual observer, this may appear like a natural step; in a world with large tradition and even larger egos, these are steps on a rocky road.

Embracing bond market pressures

There is an alternative that policy makers must contemplate: embracing the brutal pressure imposed by the bond market. It requires dealing with the reality that low interest rates must be earned. It also means that governments have to embrace the reality that they may have to renegotiate some of their debt, i.e. default. Government defaults are nothing new. However, governments should take great care that a government default does not lead to an implosion of the financial system. Banks hold substantial amounts of sovereign debt – a key reason why select banking shares are under pressure in Europe.

However, banks have one major advantage over sovereigns: they have access to central banks. While sovereigns must go into the market to fund themselves, banks may go to their central bank to obtaining funding. Banks also employ a business model that by nature has substantial leverage. While the leverage makes banks vulnerable, the banking model has two advantages:

• Central banks can keep even a technically insolvent banking system afloat. Just look at Japan in the 1990s. Similarly, the Federal Reserve (Fed) and European Central Bank (ECB) can keep even zombie banks afloat as long as they choose to.

• The reason the U.S. Treasury injected money into the banking system in the fall of 2008 (the infamous TARP program) is because the inherent leverage employed by banks allows any capital injection to support a high multiple of debt. Former U.S. Treasury Secretary Hank Paulson’s bazooka was effective because it was applied to bolstering bank capital rather than buying toxic securities outright; the latter would have turned the bazooka into a water pistol. Similarly in Europe, the focus must be on making Eurozone banks strong enough to stomach sovereign defaults.

The implication, however, is that by strengthening Eurozone banks, the sovereigns are weakened. In the U.S., while it was a gargantuan task to convince Congress to authorize TARP, a central treasury allowed swift action. The U.S. is simply better at spending and printing money than Europe. The downside is that the U.S. example proved so effective that no real reform took place (and executives were able to reap large paychecks).

A bazooka works when one has a bazooka to shoot. The reality is that in Europe, many of the sovereigns are now so weak that a bazooka may save only the banking system, not necessarily the sovereigns. Policy makers need to address this reality: in the case of a government default, it should be managed in an orderly fashion. Avoid a run on the banks by making bank deposits as secure as possible.

More practically, it also means that France, for example, must sacrifice its AAA rating in order to bail out its banks. It’s not really a sacrifice, as that rating will be stripped in due course anyway, but politically it’s a tough sell. That’s where the practical limitation of the self-sacrifice approach lies: sovereigns will be most reluctant to intentionally blow a big hole in their own shaky balance sheets to save the banking system.

As a result, expect a muddled combination of increased IMF support, increased fiscal convergence, increased focus on strengthening bank balance sheets, increased involvement to keep banks afloat (the ECB is already debating providing multi-year unlimited credit lines), and increased cost of borrowing for Germany. However, this is likely to remain a drawn out process and the tail risks that European policy makers mess this up cannot be ignored, either. We come back to our initial argument: a lot depends on perception. Perception is a function of leadership and a credible path that is likely to lead to results. The prime minister-elect of Spain wasted his first opportunity to make a good impression. The German psyche has been badly wounded by the botched auction. In typical European fashion, another summit has been announced to discuss closer fiscal integration. In case anyone wonders why this process is so painful, it is because the right decisions are politically so incredibly difficult to make.

Please make sure you sign up for our newsletter to be informed as we discuss global dynamics and their impact on currencies. We manage the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund, as well as the Merk Currency Enhanced U.S. Equity Fund. To learn more about the Funds, please visit www.merkfunds.com.

Axel Merk

Manager of the Merk Hard, Asian and Absolute Currency Funds, www.merkfunds.com

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

The Merk Hard Currency Fund (MERKX) seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Merk Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Absolute Return Currency Fund (MABFX) seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Merk Currency Enhanced U.S. Equity Fund (MUSFX) seeks to generate total returns that exceed that of the S&P 500 Index. By employing a currency overlay, the Merk Currency Enhanced U.S. Equity Fund actively manages U.S. dollar and other currency risk while concurrently providing investment exposure to the S&P 500.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds’ website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

Since the Funds primarily invest in foreign currencies, changes in currency exchange rates affect the value of what the Funds own and the price of the Funds’ shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, emerging market risk, and relatively illiquid markets. The Funds are subject to interest rate risk, which is the risk that debt securities in the Funds’ portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities, such as for- ward contracts, which can be volatile and involve various types and degrees of risk. If the U.S. dollar fluctuates in value against currencies the Funds are exposed to, your investment may also fluctuate in value. The Merk Currency Enhanced U.S. Equity Fund may invest in exchange traded funds (“ETFs”). Like stocks, ETFs are subject to fluctuations in market value, may trade at prices above or below net asset value and are subject to direct, as well as indirect fees and expenses. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds’ prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

Guest post by Axel Merk, Portfolio Manager, Merk Funds

November 1, 2011

Axel Merk November 1, 2011

Greek Prime Minister Papandreou is throwing in the towel: by calling for a popular vote on austerity measures now, we believe he is almost assured a no vote. This allows Papandreou to say that he tried everything he could to avoid a default, but the people have spoken. Having said that, as we write this analysis, Papandreou appears to be changing his mind and may cancel the idea of a referendum as quickly as it came about. Still, the message is clear: a default is coming.

The sad part is that Greece has not been able to eliminate its primary deficit (the deficit before interest payments), so that it could have the potential to bounce back upon a default. On the contrary, Greece may fall into chaos or anarchy. The threat of such a scenario, in turn, may prompt European policy makers to instigate a Marshall Plan to rebuild Greece. While we can ponder about the Greek drama, it’s paramount to contemplate the consequences for the rest of Europe and the euro.

First, the good news: market pressures should accelerate reform. Specifically, we expect bank recapitalizations will both be accelerated and increased in scope; if you can’t save the sovereigns, at least make the banking system robust enough to absorb defaults. That’s better than any insurance scheme policy makers can come up with.

Expect dramatic actions by policy makers, akin to those seen in October 2008. Just as policy makers did not initially heed the markets then, the pressure is now on to follow through with substance after last week’s sketchy plan to save Europe, and ostensibly, the world. Specifically, pressure on Italian Prime Minister Berlusconi is mounting rather dramatically to engage in real pension reform. In comparison to both Spain and Ireland, which have seen relative market improvements, the markets have scolded Italy. While it is possible to turn the tide, the longer the wait, the more the market will demand.

What would alleviate the pressure is a commitment by the European Central Bank (ECB) to be the lender of last resort for Italy and Spain. However, that’s unlikely to happen, at least not in the short term. As of today, the ECB has a new leader, Mario Draghi. As an Italian, he will be under pressure to be rather hawkish. His first press conference is this Thursday. He could announce a program to buy unlimited Eurozone debt, and sterilize such activities. However, such a move would take the pressure for reform away. And a central bank’s role is not to make the life of policy makers easy. If Draghi were to pursue the route of least resistance, he could easily be labeled as, well, Italian, in his approach to central banking.

Any revised bailout fund for Italy is likely to cost France its AAA rating. France itself also has lots of homework to do. The lesson here is that policy makers always wait until the last minute to engage in reform; some day down the road, the market will focus on the U.S.; at that stage, the U.S. dollar may be under severe pressure: the U.S. dollar is more vulnerable given the significant current account deficit.

So for now, the drama continues. To summarize, expect more on bank recapitalization and reform. A wild card is whether the European Financial Stability Facility (EFSF) is going to be bolstered in earnest. For those politicians that still believe Greece can be held afloat: stop believing in fairy tails and move on. The market will.

As far as our positioning is concerned, we had increased our euro holdings ahead of the summit last week. We have since reduced it. We had also substantially reduced the yen ahead of that summit. Our outlook calls for substantial volatility in all currencies, except for possibly the yen; as such, our risk assessment is currently favoring the yen disproportionally. As October 2008 has taught us, though, rational investors may be forgiven for changing their view of the world on a daily basis… Stay tuned and subscribe to Merk Insights.

Axel Merk
President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds

This report was prepared by Merk Investments LLC, and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice.

Guest post by Axel Merk, Portfolio Manager, Merk Funds

October 27, 2011

Axel Merk October 27, 2011

The markets appear euphoric about the ability for European policy makers to deliver on new promises. Low market expectations were met. We, too, have a positive takeaway, but only because of one detail of the grand plan; actually, let’s call it a “grand sketch,” as many details are still unknown.

The Good

Just as the U.S. bailout fund “TARP” was used to bolster U.S. banks as opposed to buying toxic securities in the market, the most effective tool to bolster confidence in the Eurozone is to ensure banks are able to stomach losses on their sovereign debt holdings. The movement to focus on banks in earnest started earlier this month. On October 5, 2011, German chancellor Merkel embraced the notion that bank capital must be bolstered; we turned significantly more positive on the euro that day. Her change of heart came after the market had provided ample “encouragement,” in the form of widespread selling of bank shares and debt; the process had been enabled by European stress tests that disclosed sovereign debt holdings in detail.

This is real money that banks will need to raise. The financial system, as a result, will be substantially more robust. Relevant for the euphoria is that there is a focus on bank capitalization. Regulators have started to embrace market value assessments, another huge positive.

Just like many, we would like even higher capital targets. One has to be realistic, though, that bank capital alone will not unfreeze interbank lending markets. Banks with a tier one ratio of 9% must still finance 91 percent of their balance sheet. We must move away from myopic bank regulation coercing banks to favor domestic sovereign debt to a pan-European approach where corporate debt (the interbank lending is lending amongst financial institutions, which are corporations) is valued on its merits rather than regulation.

The Bad

Greece. A debt write-off before a country has been able to achieve a primary surplus (budget deficit before interest payments) is counter-productive, as it takes away a powerful incentive to invest and engage in further reform. Having said that, this is mostly bad for Greece; financial institutions have now been warned that they must have adequate buffers going forward. We avoided a 60% write-off, and may end up with two 50% write-offs. Consider, though, that 18 months ago pundits called for an implosion of the financial system should Greece default. Then, the euro was trading around 1.20 versus the dollar. Now Greece clearly defaults (even if it is possible to avoid the triggering of credit default swaps), but the euro is trading at over 1.40.

The Ugly

The European Financial Stability Facility (EFSF) that’s touted to protect one trillion euros is a scheme where even policy makers don’t yet know what exactly it is going to look like. It is not a “bazooka,” as it cannot refinance itself at the European Central Bank (ECB). Indeed, gearing it up appears to be done through the back door, by making it an insurance scheme. Even so, it only has a fraction of the capital paid-in of what its commitments are going to be. As such, it’s a smokescreen, albeit a very powerful one. In a leveraged world, appearances count for a lot. However, it would be far healthier for policy makers to finally realize that de-leveraging is the answer, not to put up ever-greater commitments that –particularly in the case of Greece – may well be called upon.

The good news is that the markets will be vigilant. When the current euphoria is over, the bond market will have little mercy with those ducking from their responsibilities. And that’s a good thing that should continue to prove wrong those that have called for the demise of the euro. Long live the euro! Starting November under new leadership at the ECB. Talking about leadership: Has anyone noticed that the Federal Reserve might be paving the way for QE3?

Axel Merk
President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds

Guest post by Axel Merk, Portfolio Manager, Merk Funds

October 12, 2011

To ensure the European sovereign debt crisis doesn’t go to waste, the markets have kept policy makers and bankers on their toes. The naysayers of a European turnaround have become so overwhelming that it is stunning Europe hasn’t submerged into the Atlantic Ocean yet. It appears that German Chancellor Angela Merkel, the cautious woman with the checkbook, is about to turn the tide.

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We are seeking your donations to the American Cancer Society – Merk will match donations.
Please click here for more details.

First off, Greece would likely default, possibly within weeks, if it were not for the efforts being made to postpone the inevitable until next spring. The driving force behind the Greek drama and its potential fallout has primarily been played out in the bond markets. Indeed, it appears the only language policy makers understand is that of the bond market. In this context, it’s quite astonishing how much progress has been made. Italy, for example, passed substantial reforms three times this year. And for those who worry that the politics of austerity measures may topple governments, and thus the reform process itself, fear not: in Spain, for example, early elections in November will likely have the current opposition sweep to power. The main implication in Spain will be that the new government will own the same old problem, but may have a stronger majority to engage in reform. In Germany, where many fear the junior coalition partner will at some point cause the government to collapse, note that the major opposition parties favor Eurobonds and possibly a Marshall Plan for Greece; both such plans would likely appease bond markets.

When it comes to banks, it’s again the market calling the shots. While banks had ample opportunity to bolster their balance sheets – and in all fairness some have done so – bank boards have been hiding behind their regulators. Bank regulation is deeply flawed, as it favors holding domestic sovereign debt and discourages marking positions to market. In Europe, a strong pan-European regulator is urgently needed to put a meaningful dent into this culture. Fear not: the markets haven’t waited for regulators to get their act together. The latest round of European stress tests was most meaningful, because it provided transparency on the sovereign debt exposures of European banks. As a result, the market provided “encouragement” to weak banks to raise more capital. In a strange way, that process has been working wonderfully, culminating in German chancellor Merkel throwing her weight – and checkbook – behind the initiative.

Although the debate should be playing out mostly in the spreads in the bond markets, i.e. the difference between the cost of borrowing between the stronger and weaker Eurozone countries (with respect to banks, both their debt portfolio and stock market valuations have been guides in assessing their perceived health), the Euro tends to also be the focus of attention. As the Euro was plummeting towards 1.18 versus the U.S. dollar in 2010, we became outspoken ‘euro bulls’, arguing that issues in the Eurozone should primarily be reflected in the spreads in the bond market; the Euro was sold – in our view – mostly because of its great liquidity: it’s easier to sell the Euro rather than short peripheral country bonds. Indeed, the Euro since recovered substantially, while periphery nation spreads have widened.

Market volatility is the friend of strong hands. Momentum players are attracted by a market that goes up (or down) in what approximates a straight line, be that the stock market, gold, the Swiss franc or euro. When such a trade is no longer perceived to be risk free, volatility returns to the market; those trend chasers run for the exit, often causing sharp corrections. Volatile markets force investors to think for themselves: is blood on the streets a unique opportunity for the contrarian investor or an omen for even more extreme conditions?

Just about a month ago, we turned cautious on the euro, as the tail risks became evermore likely to unfold. However, in a world where policy makers are throwing billions and trillions at the problems, market fundamentals can quickly change. And so it is that our assessment of the likely outcome for the euro has changed. Last Wednesday, Olli Rehn, EU commissioner on monetary affairs, suggested bank recapitalizations ought to take a high priority. When the woman with the checkbook echoed his assessment, we decided that major progress had been made. German chancellor Angela Merkel has come to the realization that bolstering bank balance sheets may be the most effective way to build the “ring of fire” around Greece’s impending default. Over the weekend, French President Sarkozy has fallen in line with Merkel’s new agenda; unlike the German Chancellor, Sarkozy wants to rely on the European Financial Stability Facility (EFSF) as a primary, rather than last, resort; his different perspective is not surprising given the substantial exposure of the French banking system to Greece.

In 2008, the infamous TARP program put in place to rescue the U.S. financial system opted to inject money into the banking system rather than buy “toxic assets.” As politically painful as it may seem to “bail out the banks”, this is where capital is most effectively deployed, for the very simple reason that banks can leverage the capital. A Euro spent on buying Italian debt is a Euro spent; a Euro injected into a bank can support ten times as much capital, or more. We are not advocating to increase bank leverage, but to regain market confidence, banks must have adequate cushions to allow for “haircuts” of debt held by the banks; in the case of U.S. banks, it was mortgage backed securities, amongst others; in Europe, it’s sovereign debt holdings of “peripheral” Eurozone countries.

After the current short squeeze in the Euro has run its course, investors may be surprised to see the rally continue on the backdrop of more positive scenarios being priced into the markets. Ironically, the biggest risk to a positive outcome is market complacency. As soon as market pressures abate, policy makers tend to lose their enthusiasm to make tough decisions. Fortunately, there are plenty of minefields along the way, ensuring that policy makers should remain on alert.

Subscribe to Merk Insights to be informed of our analysis as this crisis evolves; please also sign up to our Webinar on Thursday, October 20, 2011, to provide a live analysis on global dynamics, the U.S. dollar and the Merk Funds. We manage the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund, as well as the Merk Currency Enhanced U.S. Equity Fund. To learn more about the Funds, please visit www.merkfunds.com.

Axel Merk

Manager of the Merk Hard, Asian and Absolute Currency Funds, www.merkfunds.com

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

The Merk Hard Currency Fund (MERKX) seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Merk Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Absolute Return Currency Fund (MABFX) seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Merk Currency Enhanced U.S. Equity Fund (MUSFX) seeks to generate total returns that exceed that of the S&P 500 Index. By employing a currency overlay, the Merk Currency Enhanced U.S. Equity Fund actively manages U.S. dollar and other currency risk while concurrently providing investment exposure to the S&P 500.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds’ website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

Since the Funds primarily invest in foreign currencies, changes in currency exchange rates affect the value of what the Funds own and the price of the Funds’ shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, emerging market risk, and relatively illiquid markets. The Funds are subject to interest rate risk, which is the risk that debt securities in the Funds’ portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities, such as for- ward contracts, which can be volatile and involve various types and degrees of risk. If the U.S. dollar fluctuates in value against currencies the Funds are exposed to, your investment may also fluctuate in value. The Merk Currency Enhanced U.S. Equity Fund may invest in exchange traded funds (“ETFs”). Like stocks, ETFs are subject to fluctuations in market value, may trade at prices above or below net asset value and are subject to direct, as well as indirect fees and expenses. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds’ prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

Guest Post by Axel Merk, Portfolio Manager, Merk Funds

October 4, 2011

Is Operation Twist a failure? The stock market plunged in disappointment when it was announced. Keynesians are tearing their hair out in frustration, as it appears the Fed failed to ramp up the printing press. Free marketers are disgusted by the blatant manipulation of the yield curve. A number of Federal Reserve (Fed) President Bernanke’s colleagues dissented and/or are voicing public opposition. However, as the dust settles, it appears there is a method to the twist: Bernanke may have a plan…

To understand where we may be heading, let’s look at where we have come from. Below is a graphical depiction of the Federal Reserve’s holdings of Treasury securities on its balance sheet; the different colors represent the evolving composition of the maturity of assets held by the Fed:

One does not need to be an economist to see that the Fed has already been “twisting” its holdings of Treasury securities. It used to be that over 50% of Treasuries held by the Fed had a maturity of less than a year. That portion has already shrunk dramatically. Operation Twist is going to focus on the purple shading, replacing many of these securities with longer-dated ones. Differently said, Operation Twist really is nothing new, but an extension and expansion of policies in place since 2008.

Indeed, Bernanke has a playbook, hiding in plain sight: in his 2002 speech that earned Bernanke his nickname as “Helicopter Ben”, he laid out his plan when faced with the threat of deflation. Whereas his predecessor Paul Volcker took years to convince the markets that the Fed was serious about fighting inflation, Bernanke appears to be relentless in trying to convince the markets that deflation is not going to happen in his back yard. But why not simply print more money as the economy has slowed (engage in “QE3”)?

It looks like Bernanke at least wants to maintain the appearance of keeping long-term inflation expectations low. Earlier this year, Bernanke complained a few times that the risk-reward ratio of another round of easing is not all that clear. Well, how about making it clearer, by:

• First crushing the short end of the yield curve by committing to keep interest rates low until the middle of 2013.
• Then lower long-term interest rates by initiating “Operation Twist”, the selling of short-term securities by the Fed in the billions, then reinvesting the proceeds in long-term securities.

Add to that overall gloomy economic data, and conditions may be ripe for inflation expectations, as priced into bond price differential with and without inflation protection, to drop. Sure enough, that is exactly what has been playing out; the chart below depicts inflation expectations over a nine year period, beginning one year from today (referred to as “forward” inflation expectations, as it filters out inflation expectations over the short-term; this approach helps adjust for inflation shocks that may be presumed to be transitory in nature).

What this chart shows is that recent communication and action by the Fed may have contributed to an environment closer to where Bernanke would like to see: with inflation expectations low, Bernanke is back in familiar territory, able to print more money. A reason why the Fed first needed to set the stage is because the Federal Open Market Committee (FOMC) has a couple of outspoken hawks¹ that, as we have alluded to, are not afraid to voice their dissent:

Incidentally, the 2012 FOMC composition reflects that hawks are snowbirds; only one hawk will remain. A stranded hawk may be noisy (dissent and speak out), but might stand little chance against a flight of doves²:

Let us review the Bernanke playbook; all quotes below are taken from his 2002 speech:

Bernanke is determined

• “First, the Fed should try to preserve a buffer zone”, i.e. an implicit or explicit inflation target between 1 and 3 percent.
• “Second, the Fed should take most seriously … its responsibility to ensure financial stability.”
• “Third, …the central bank should act more preemptively and more aggressively…”

Bernanke on Operation Twist:

• “One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure – that is, rates on government bonds of longer maturities.”
• “I personally prefer…for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years).“
• “The Fed might next consider attempting to influence directly the yields on privately issued securities…the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. “

Bernanke may want a weaker dollar:

• “U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press…that allows it to produce as many U.S. dollar as it wishes at essentially no cost.”
• “By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar…”
• “The Fed has the authority to buy foreign government debt… Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S.”

While Bernanke cautions that the Fed might step on the toes of the Treasury by targeting a weaker U.S. dollar, he actively embraces a weaker currency as a tool to spur nominal growth. Bernanke’s primary concern appears to be not one of determination, but one of calibration: “One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies.”

Enough said. While the markets have been “disappointed”, when push comes to shove, Bernanke has stuck to his playbook. He has paved the way for QE3. We have argued that there may not be such a thing as a safe asset anymore, and that investors may want to take a diversified approach to something as mundane as cash. Investors may want to actively manage their U.S. dollar risk, be that for their domestic or international investments. After all, investors may want to position their portfolios to take the risk that Bernanke will do what he has said into account.

We manage the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund, as well as the Merk Currency Enhanced U.S. Equity Fund. Please join us for our Quarter 3 Merk Webinar on Thursday, October, 20th at 4:00pm ET / 1:00pm PT. To learn more about the Funds, please visit www.merkfunds.com. Please sign up to our newsletter to stay in the loop as this discussion evolves.

Axel Merk

Manager of the Merk Hard, Asian and Absolute Currency Funds, www.merkfunds.com

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

Disclosures:

The Merk Hard Currency Fund (MERKX) seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Merk Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Absolute Return Currency Fund (MABFX) seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Merk Currency Enhanced U.S. Equity Fund (MUSFX) seeks to generate total returns that exceed that of the S&P 500 Index. By employing a currency overlay, the Merk Currency Enhanced U.S. Equity Fund actively manages U.S. dollar and other currency risk while concurrently providing investment exposure to the S&P 500.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds’ website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

Since the Funds primarily invest in foreign currencies, changes in currency exchange rates affect the value of what the Funds own and the price of the Funds’ shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, emerging market risk, and relatively illiquid markets. The Funds are subject to interest rate risk, which is the risk that debt securities in the Funds’ portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities, such as for- ward contracts, which can be volatile and involve various types and degrees of risk. If the U.S. dollar fluctuates in value against currencies the Funds are exposed to, your investment may also fluctuate in value. The Merk Currency Enhanced U.S. Equity Fund may invest in exchange traded funds (“ETFs”). Like stocks, ETFs are subject to fluctuations in market value, may trade at prices above or below net asset value and are subject to direct, as well as indirect fees and expenses. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds’ prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

¹Generally speaking, a central banker may be considered a hawk if his or her monetary policy stance is perceived to focus more on inflation and less on expansionary policies.
²Generally speaking, a central banker may be considered a dove if his or her monetary policy stance is perceived to focus more on stimulating employment and economic growth and less on inflation.

Guest post by Axel Merk, Portfolio Manager, Merk Funds

September 21, 2011

In 2008, the global financial system faced a potential meltdown when funding seized up for investment banks, ultimately leading to the failure of Lehmann Brothers. Three years on, we have got plenty of problems, but – as we shall argue – investors may want to differentiate between a financial meltdown and insolvency. While complaining about policy makers and bankers may generate animated water cooler discussions, let’s take their human (and fallible) nature as a given, and discuss implications for investors. In this context, we assess the U.S. dollar, currencies and equities.

Introducing the Merk Currency Enhanced U.S. Equity Fund with Axel Merk
Merk Webinar: Thursday, September 22 at 4:00pm ET / 1:00pm PT
Click here to Register

In recent months, various observers pointed to strains in the inter-bank funding markets. Headlines warning of financial calamity resurfaced. We have a laundry list of complaints ourselves. Remember, though, that Al Capone was convicted for tax evasion, not for his activity as a mobster. Credit Default Swaps (CDS) on Greece may be triggered not by Greece’s inability to pay, but because of Finland’s insistence that collateral be posted in return for the next tranche of European Financial Stability Facility (EFSF) payment. Along similar lines, select banks may have funding strains, but don’t count on a lack of liquidity breaking their backs.

Anyone who has read a basic accounting book recalls the equation Assets = Liabilities + Owner’s Equity. While specifics might get a bit complex (they shouldn’t, but when regulators and lobbyists collaborate, the result is not necessarily the most obvious), banks face the same accounting realities. A customer’s loan shows up as an asset on a bank’s balance sheet. Equity may be paid-in capital by shareholders. And liabilities are the loans the bank itself takes out in order to pay for (fund) its loan portfolio (assets). Unlike non-financial corporations, banks are highly leveraged institutions (low equity compared to liabilities); moreover, banks have an inherent maturity mismatch. A maturity mismatch means that banks tend to borrow short-term money, while financing long-term projects. Some of the key risks banks face are interest risk (the risk of rising short-term interest rates may create problems for institutions with a maturity mismatch) and credit risk (the risk of creditors not paying back their loans). By promising to keep interest rates low until at least the middle of 2013, the Federal Reserve (Fed) has substantially reduced interest risk for banks. The risk of creditors (think Greece’s sovereign debt; think sub-prime mortgage-backed securities, to name two of the more obvious risks), however, persists.

In order to finance their loan portfolios (a bank asset), banks have substantial funding risk. Funded can be sourced through customer deposits (a fairly stable source of funding; a customer deposit shows up as a liability on a bank’s balance sheet), by issuing various forms of debt (e.g. including longer term bonds or shorter term commercial paper) or by obtaining a loan from another financial institutions, the inter-bank lending market.

The obvious challenge in the interbank lending market is that if a bank does not trust another institution’s financial health, they are unlikely to give that institution a loan, even if it is just overnight. The financial institution seeking to secure financing may have its funding costs soar as a result. The important thing to remember, though, is that banks have access to funding from their respective central banks. The days are over when investment banks had neither customer deposits, nor access to a central bank window. Goldman Sachs, as well as the other remaining large investment banks, have converted to commercial banking charters. As such, they can tap into the same unlimited piggy bank as other banks. Importantly, the European Central Bank (ECB) has been providing unlimited liquidity to the European banking system. That’s unlimited, as in no limits. The banks are depositing part of their loan portfolio as collateral; in return, they receive cash. That cash may literally be printed out of thin air; central banks don’t need to find that money somewhere, they just need to enter a credit into the account that bank holds at the central bank.

It turns out the ECB model is rather flexible: when the crisis flares up, banks require more liquidity; when the crisis ebbs down, those facilities are wound down. The ECB has been adamant that their measures are temporary by design and independent of its broader monetary policy. While one can argue about the severity of the crisis or the quality of the collateral, it is correct that the ECB approach is more robust than that of the Federal Reserve (Fed). By buying trillions in mortgage-backed securities (MBS) and government bonds, the Fed has a bloated balance sheet that is cumbersome to manage. In contrast, the ECB has only printed a fraction of the money and could phase out its facilities within months (one year for the longest facility). The ECB is also providing unlimited U.S. dollar liquidity to European banks through swap arrangements with the Fed in cooperation with the Swiss National Bank (SNB) and Bank of England (BoE). Importantly, these facilities are designed to carry financial institutions through the New Year. Towards the end of the year, a lot of window dressing takes place, where financial institutions like to show “good” securities on their books. As a result, every year, there is concern that those issuing less desirable securities might get squeezed from the funding markets. While not without political risks in the U.S., it shows the determination of central banks to keep plenty of liquidity in the markets, and is a key reason why we believe a liquidity driven financial meltdown is off the table.

In the 1990s, the Bank of Japan showed that even a technically insolvent banking system could be kept afloat. Similarly, there may be solvency issues at some institutions, but central banks can keep them afloat.

When funding costs are too high, financial institutions have to de-leverage or raise more capital. The former can be expensive; indeed, banks have great leeway with regards to keeping securities at cost on their books, rather than adjusting them to market value. Part of the rational behind such regulation is that the maturity mismatch inherent to the banking industry means banks should be able to take a longer-term view. The markets have shown they have little sympathy for such twisted logic. The trouble is that, if indeed banks de-leveraged, they would have to recognize their losses, possibly wiping out substantial portions of their capital.

The latest round of European stress tests did something fabulous: the stress tests provided unprecedented transparency, listing the sovereign debt holdings of financial institutions. The market doesn’t need the regulator to tell them what’s good or bad; the market needs transparency. The market is now able to target what are deemed weaker institutions and “encourage” them to raise more capital or de-leverage. That ‘encouragement’ by the market is what has been driving both policy makers and bank executives. In many ways, it’s a wonderful dialogue. Policy makers and CEOs may be able to influence the timing of when governments and banks clean up their books / get their act together, but the action is firmly driven by the bond markets. However, there is one region where this “reform process” is sorely lacking with regards to sustainable fiscal policy: the U.S. It’s not a coincidence: the bond markets in the U.S. have not forced policy makers into action. Obviously it would be preferred to have policy makers and bank CEOs be ahead of the curve.

When it comes to financial institutions, the inherent design of bank regulation carries much of the blame. It’s not just the fact that banks are not required to mark down assets to market value; it’s also that national regulators typically consider their own government debt risk free. In the U.S., Treasures are risk free by regulation. Similarly, European banks ought to carry much of their capital in sovereigns, as those securities are acceptable to comply with capitalization rules; in contrast, corporate securities must be heavily discounted. In a world where some corporations may be less risky than their governments, those rules are outdated. Indeed, at times, there is a risk that inter-bank lending of corporate (financial institution) paper dries up, because regulation discourages taking on the counter-party risk of a bank and incentivizes more risky government securities instead. In Europe, where each Eurozone government regulates its own banking system, it’s urgently necessarily to centralize bank regulation, so that each member country’s bank is not ex-ante over-exposed to their own government paper. Naturally, the respective governments are opposed to such moves, as it may increase the cost of government funding if banks actually had to evaluate (and take seriously) the creditworthiness of their own governments.

What does it mean to investors?

• Banks that are under-capitalized may not lend as much, reducing economic activity. That may be a negative for equities. For currencies, however, it depends. In Japan, the yen has been benefiting from economic contraction: in the absence of a current account deficit, consumers save more as economic activity slows down. In the U.S., it’s the opposite: it’s easier to finance the current account deficit with economic growth, providing an incentive to policy makers to grow at just about any cost. Looked at it differently, the U.S. dollar may be much more sensitive to a misbehaving bond market; while it is behaving for now, the U.S. dollar may be under pressure should the market take a different view on long-term fiscal sustainability. Caught in the middle is the euro: with the current account roughly in balance, the euro can fare okay in an environment where banks restrict their lending and economic activity stalls.
• Volatility is likely to remain elevated as long as investors remain skittish regarding the amount of liquidity provided. However, keep in mind that central banks can act much faster than politicians. As liquidity concerns are addressed, the market will move towards focusing on solvency issues. The lines may be blurred at times because of above mentioned regulations and lack of transparency. It would be most helpful if policy makers decided to embrace transparency. Note, by the way, that there is nothing inherently bad about a bank de-leveraging; but by postponing the inevitable, stress is created in the system that benefits no one (except those shorting those banks, I suppose, which is then made banned by the regulators…but I digress).

Because of the scale of the issues, policy makers have taken an ever more active role in the markets; we don’t see that trend abating. As a result, securities may increasingly be trading based on the next perceived move of policy makers, rather than on fundamentals. It’s a key reason why we focus on currencies, as, through the currency markets, investors can take positions on what we call the mania of policy makers. This Thursday, September 22, 2011, we are hosting a webinar discussing how investors may be able to manage the currency risk of their U.S. equity portfolio (click here to register). According to our analysis, investors may be able to improve risk-adjusted equity returns by taking a pro-active approach to currency risk (please also read our white paper on the topic).

We manage the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund, as well as the Merk Currency Enhanced U.S. Equity Fund. To learn more about the Funds, please visit www.merkfunds.com. Please sign up to our newsletter to stay in the loop as this discussion evolves.

Axel Merk

Manager of the Merk Hard, Asian and Absolute Currency Funds, www.merkfunds.com

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

The Merk Hard Currency Fund (MERKX) seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Merk Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Absolute Return Currency Fund (MABFX) seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Merk Currency Enhanced U.S. Equity Fund (MUSFX) seeks to generate total returns that exceed that of the S&P 500 Index. By employing a currency overlay, the Merk Currency Enhanced U.S. Equity Fund actively manages U.S. dollar and other currency risk while concurrently providing investment exposure to the S&P 500.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds’ website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

Since the Funds primarily invest in foreign currencies, changes in currency exchange rates affect the value of what the Funds own and the price of the Funds’ shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, emerging market risk, and relatively illiquid markets. The Funds are subject to interest rate risk, which is the risk that debt securities in the Funds’ portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities, such as for- ward contracts, which can be volatile and involve various types and degrees of risk. If the U.S. dollar fluctuates in value against currencies the Funds are exposed to, your investment may also fluctuate in value. The Merk Currency Enhanced U.S. Equity Fund may invest in exchange traded funds (“ETFs”). Like stocks, ETFs are subject to fluctuations in market value, may trade at prices above or below net asset value and are subject to direct, as well as indirect fees and expenses. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds’ prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

Guest post by Axel Merk, Portfolio Manager, Merk Funds

August 24, 2011

A key reason for recent market turmoil may be the long overdue untangling of important debt-driven interdependencies between the U.S. and Europe. In our analysis, not only has the Federal Reserve’s (Fed’s) ultra-low monetary policy taken away any incentive to engage in meaningful reform in the U.S., but the easy money also spilled far beyond U.S. shores, providing European banks with hundreds of billions of reasons not to shore up their capital bases. With volatility riding high, investors appear to be chasing emotions rather than facts; let’s take a step back, and in an effort to understand where the Fed, the U.S. dollar and the euro might be heading next, let’s focus on facts rather than emotion.

The recent bout of volatility started when fears of renewed tensions in the Eurozone banking system erupted. The cost of funding for select institutions was on the rise. With memories of 2008, fears of a systemic shock, possibly the result of a bank failure, sent stocks plummeting. However, these challenges should not have come as a surprise. As we have learned over and over again, the players in this crisis are primarily motivated to act by market pressure, be that policy makers engaging in fiscal reform or banks bolstering their balance sheets. European banks have had a cozy relationship with their own regulators, as well as U.S. money markets, providing disincentives to get their acts together. Specifically, U.S. taxable money market funds, in search of yield, had been funding European banks by gobbling up U.S. dollar denominated commercial paper issued by these institutions. Only after criticism of this practice could no longer be ignored, including our June 22, 2011, analysis entitled “Euro: Safer than the U.S. Dollar?”, was the practice reduced. Institutional investors dumped their money market fund holdings; in turn, money market fund managers have reduced their holdings of commercial paper issued by European banks. As a reminder, these money market funds were holding massive positions, often substantially in excess of 50% of their net assets, in banks such as BNP Paribas, that in turn have billions of exposure to Greek debt.

Not surprisingly, the cost of funding for those European banks soared after being shunned by U.S. money market funds. The European Central Bank (ECB), as a response, announced on August 4, 2011, that it would once again open its six-month refinancing facility, providing unlimited liquidity to the banking system. What observers failed to realize was that this is not due to new problems, but due to old problems finally being addressed. Very helpful in this context was that the European stress tests released on July 15, 2011, have finally brought unprecedented transparency to the banking system by providing details of sovereign debt holdings of European institutions. It’s not about whether these tests were rigorous enough, but that the market is now able to “encourage” banks to raise more capital by, for example, shunning them from the inter-bank lending markets. Until then, the Fed’s policies have helped to cover up the weaknesses of the European banks affected. In fairness to the Fed, U.S. money market funds are part of what is called the shadow banking system, as money market funds operate outside of the supervision of the Fed. But money market funds have been chasing yields of riskier assets as a result of the low interest rate environment the Fed has imposed on the market; in an environment where Treasuries yield near zero (at times even less than zero), it puts strains even on the most conservative of investors.

Let’s keep in mind, though, that we are not in 2008. Since 2008, the remaining investment banks have converted to banking charters that give them access to central bank lending facilities. As a result, central banks are capable of keeping a banking system afloat, even if it were technically insolvent. All stakeholders should embrace the stress in the markets as an encouragement for further reform. Unfortunately, policy makers on both sides of the Atlantic are utterly slow to engage in urgently needed reform. In the U.S., with a “behaving” bond market, we are not even scratching the surface of what would put the U.S. on a sustainable fiscal path. In Europe, it’s perfectly understandable that Germany is pushing back against writing blank checks to bail out weaker countries, but we need more than speeches on closer fiscal integration. But don’t despair: the market will not wait. Think about it this way: any country that has asked for help from the IMF or the Eurozone had to give up sovereign control over their budgeting. Isn’t that exactly what German Chancellor Merkel and French President Sarkozy are calling for? The difference between what the market is imposing and policy makers are calling for is one of process: stressful periods are less stressful if sound institutional processes are in place. But even in the absence of such processes, the reform movement continues. It just happens to be a rather ugly and painful affair with plenty of political minefields.

Talking about these minefields: many have warned that policy makers might be voted out of office, potentially jeopardizing policies. Indeed, policy makers may lose their jobs, but that won’t change bond vigilantes: the language of the bond market is the only language policy makers appear to listen to. As a result, kick out one government and the primary consequence is that a new government now owns the same problem. In Spain, early national elections have been called for in November; odds are that the opposition will sweep to power, giving the new government, well, a way to accelerate reform.

We are not suggesting that these reforms will all be implemented to everyone’s, or even anyone’s satisfaction. However, we believe that the drama playing out in the Eurozone is one of process, an ugly process in which challenges are primarily expressed in the bond spreads in the Eurozone. In this environment, the Euro may strive, despite or possibly because of, all the pain, because less money is being spent than in the U.S.

There is also far less money printing in the Eurozone versus the U.S. In the U.S., we have no exit from “QE2”: all the money that has been printed remains in the system. What has changed is that words may count again, highlighted by the latest initiative by Fed Chair Bernanke. Since 2007, U.S. monetary policy has become ever more expensive, as rate cuts were followed by emergency rate cuts, followed by printing billions, then trillions. With the commitment to keep interest rates low until mid 2013, Bernanke has managed to depress interest rates with a statement rather than the printing press. While we strongly disagree with the policy, we must acknowledge this a major development. In many ways, Bernanke has doubled down on the Fed’s credibility. However, given that the Fed has rarely ever been accused of being too far sighted, I interpret the latest policy as just that: a policy for now, subject to change. Importantly, the Fed may continue to play with the “size and composition” of its balance sheet; if further action takes place, the Fed may first re-invest proceeds of securities it holds into longer-dated securities, to further depress the long-end of the yield curve. However, the most likely scenario, in our view, is that Bernanke will explain his recent actions rather than announce major new initiatives when he speaks at the annual gathering of global central bankers in Jackson Hole later this week.

By talking down interest rates, Treasury securities appear to offer unattractive returns to rational investors: negative real interest rates are being priced into the market. Similar to quantitative easing, this may provide further negative dynamics for the U.S. dollar, as investors are not getting properly compensated for the risks they are taking on. Bernanke, in our assessment, is employing the U.S. dollar as a monetary policy tool. Remember: Bernanke has even testified that going off the gold standard during the Great Depression, i.e. debasing the U.S. dollar, helped the U.S. recover faster from the Great Depression than other countries that held on to the gold standard for longer.

It’s in this context that we are negative on the dollar and positive on the euro: the Eurozone is on the other side of Bernanke’s version of the Great Depression trade. Indeed, while there’s been plenty of lamenting about ECB policy, the European Central Bank has printed a fraction of the money that the Fed has; the chart above depicts the growth of balance sheets (a proxy for the money that has been printed by the respective central bank) relative to August 2008.

And as far as the “behaving” bond market in the U.S. is concerned? The time may come when U.S. bond vigilantes will demand fiscal reform. The difference to the European experience is that the U.S. has to finance a current account deficit; as a result, the U.S. dollar may be far more at risk than the euro; in the Eurozone, the current account is roughly in balance. As the Japanese experience has shown, countries that don’t rely on foreigners to finance their deficits may experience strong currencies on the backdrop of economic stagnation.

In a nutshell, the U.S. is leading the developed world at spending and printing money. As a result, there may be no such thing anymore as a safe asset and investors may want to take a diversified approach to something as mundane as cash. Investors may be over-exposed to the U.S. dollar and may want to consider managing the currency risk of their investments more actively. We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com. Please sign up to our newsletter to stay in the loop as this discussion evolves.

Axel Merk

Manager of the Merk Hard, Asian and Absolute Currency Funds, www.merkfunds.com

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

The Merk Hard Currency Fund (MERKX) seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Merk Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Absolute Return Currency Fund (MABFX) seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds’ website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds own and the price of the Funds’ shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds’ portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds’ prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

Guest Post by Axel Merk, Portfolio Manager, Merk Funds

July 20, 2011

Today’s debate may be focused on whether the debt ceiling will be raised, but it’s tomorrow’s debate that really concerns us. Last week, Standard & Poors made it clear that raising the debt ceiling would be one thing, but in order to withhold a downgrade to the U.S. credit rating, the U.S. must show that it is not “maxed out.” In other words, show that it would be able to manage another crisis, or a potential war. What would be the implications of a credit downgrade? And what policies would need to be engaged in, in order to avert a downgrade and strengthen the U.S. dollar over the long-term?

Just recently, investors shrugged off the notion that ratings agencies might downgrade U.S. debt. After all, just about all U.S. debt is denominated in U.S. dollars, thus making an outright default more of a theoretical possibility, given that the Federal Reserve (Fed) is capable of simply printing money as the lender of last resort. However, that view has been weakened of late:

• The debt ceiling mandated by Congress may lead to an actual default. While raising the ceiling mostly appears to be a game of political chicken, the fallout from the subprime debacle has meant that ratings agencies do not want to be caught late in downgrading anyone these days.
• Presently, ratings agencies appear to be more closely scrutinizing inflation, as a result of printing money, as a form of default.
• Even if the Fed were to print money to cover any shortfalls not financed by private and foreign lenders, the math simply does not add up. In the absence of entitlement reform, mandatory spending will be so overwhelming down the road that a default may be inevitable. Not today, not tomorrow, but in the decades to come.

Unfortunately, we have seen in Europe that the only language policy makers understand is that of the bond market; it is rather astounding how weak European governments, at times minority governments, have engaged in substantial reform and austerity measures. In our assessment, because the government and Fed came to the rescue of everyone, the will for true reform was lost in the U.S.; it may require a derailment of the U.S. bond market for policy makers to take reform seriously here. Unlike the Eurozone, however, the U.S. has a substantial current account deficit, which potentially makes the U.S. dollar far more vulnerable to a misbehaving bond market than the euro.

What are the implications for the U.S. dollar if ratings agencies downgrade the U.S.’s credit rating? Two forces would play out: on the one hand, the cost of borrowing for the U.S. might climb, making it all the more difficult to attract money to finance the current account deficit. This downward pressure on the U.S. dollar may be offset by a general de-leveraging that may ensue: as U.S. debt is downgraded, anyone using U.S. government debt as collateral for leveraged transactions may need to provide more collateral. As an example, in the futures markets, 90% of the face value of Treasury Bills is typically counted as collateral towards potential losses of open positions. In face of a lower credit rating, more collateral may be required for the same positions. Differently said: we may see another wave of global de-leveraging. Lehman Brothers is a stark example of what can happen when leveraged players are unable to de-leverage. Different from 2008 is that we now know the playbook of policy makers; except, of course, that Congress (and parliaments around the world) might not come to the rescue of the markets because of the political risks associated with further bailouts. That then puts the pressure on central banks; in this context, the Fed has been the most willing to keep the U.S. and global monetary system lubricated. If nothing else, heightened volatility may result (which in itself causes de-leveraging, making it all the more difficult for monetary policy to stem against market forces to reflate the financial system).

Looking beyond those challenges, what would it take for the U.S. dollar to reverse its long-term decline, so that investors not only get a return of their money, but a return on their money? Higher interest rates won’t necessarily do it: historically, when rates go up in the U.S., the bond market experiences a bear market. Because foreigners tend to hold a lot of U.S. bonds, the U.S. dollar may come under pressure when bond holdings are liquidated. The U.S. dollar may only benefit in the late stages of a rate hiking cycle, as a new bond bull market is anticipated.

What we are looking for, plain and simple, are policies that foster increases in savings and investment. In contrast, U.S. policies appear to promote growth at any cost and, if anything, act as a disincentive to saving. Policy makers talk about increasing savings and investment, but typically prefer that to happen once they are out of office: promoting near-term growth via ongoing spending programs and misguided policies aimed at propping the consumer up are perceived to resonate better with voters. With regards to investments, allowing companies to write off their entire investment immediately would go a long way; instead, proposals on the table in the budget debate suggest exactly the opposite, further extending the time over which investments need to be amortized. If businesses were given the choice to buy new machinery or pay Uncle Sam, many businesses would choose to invest. Did I mention machinery? Indeed, such a simple change in policy would support investment in capital-intensive industries, rather than push such industries overseas.

Savings may be promoted through higher interest rates. But there’s also a controversial fiscal tool, namely a consumption tax. A national sales tax or an energy (carbon) tax may provide an incentive to save. However, politically, such taxes are non-starters.

To get the U.S. budget on a sustainable footing, mandatory spending must be addressed. Cutting discretionary spending to zero and taxing the “wealthy” at 100% simply won’t do the trick in the long-run. Mandatory spending, i.e. spending on Social Security, Medicare, Medicaid and other health programs must be reformed. When social security was introduced in 1935, the average life expectancy was less than 62 years; currently, it is over 78 years. Countries are increasingly linking pension benefits to life expectancy (see OECD report); the U.S. must follow suit to keep social security solvent. Similarly, policy makers must find ways to get the cost of health care under control. “Eliminating inefficiencies” and price controls won’t do. Proposals to have benefits means-tested and to have beneficiaries take a more direct stake in the cost, such as through co-pays, are possible avenues.

At its heart, it is an issue of credibility. In the early ‘80s, former Fed Chair Paul Volcker had to raise interest rates dramatically to “beat” inflation, to show the markets that the Fed meant business. Today, Congress will need to show it is serious about a sustainable budget and go far beyond the “spend now, save later” approach promoted by current Fed Chairman Bernanke. As radical as some of the proposals on the table sound, they don’t even scratch the surface if long-term sustainability issues are not addressed.

We have argued for years that there may be no such thing anymore as a safe asset and investors may want to take a diversified approach to something as mundane as cash. Please join us for a Webinar on Thursday, July 21 and sign up to our newsletter to be in the loop as this discussion evolves. We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.

Axel Merk

Manager of the Merk Hard, Asian and Absolute Currency Funds, www.merkfunds.com

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

The Merk Hard Currency Fund (MERKX) seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Merk Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Absolute Return Currency Fund (MABFX) seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds’ website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds own and the price of the Funds’ shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds’ portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds’ prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.