Confirmatory bias: Yup, I don’t like the Euro

A national government that willingly gives up its sovereignty is not going to last, which is exactly what a common currency requires. In the US, States did it only after a lot of turmoil and war. Will the Euro-zone be able to pull it off long-term? I highly doubt it. It’s another soon-to-fail experiment. http://globaleconomicanalysis.blogspot.com/2009/12/eh-tu-germany-finance-minister-says-no.html

What’s interesting is that I’ve been hearing rumors that some Middle East countries are considering a common currency (Dubai is upset because the Saudis hope to be at the center of this movement). This comes about every few years as oil producing countries get tired of accepting dollars. The only thing worse than the dollar for them is their neighbors currency, which they know for sure they won’t be able to trust, so I doubt it will get anywhere, probably to the benefit of all players.

Was Japan’s QE announcement the top?

Will this week mark the cyclical top of the recent rally? I have been writing that there is a disconnect between the fundamentals of the equity market (unemployment, historically high margins that will compress, high P/E, etc.) and the performance we’re seeing. Meaning that the market was being driven by speculative positions which were probably based on flows, carry trade, global quantitative easing measures, etc. and NOT by an increased world GDP nor productivity gains.

So we’re left asking whether Japan’s signal of increased QE will market the top. I have a feeling it might. Maybe we’ll make another run, but the dislocations will have to come into balance. The interesting market will end up being the Treasury market. With flows coming into the USD, were will they sit if not in Treasuries? Not sure yet, but again, just food for thought as we position into year end and adjust medium term allocation.

Initiating new position

Over the past several weeks, a big focus for me, my clients, and our community has been currency, and especially the relationships of gold and the equity markets to different currency pairs. As I’ve mentioned, I initiated a position in long USD vs yen and long USD vs. Euro a couple of weeks ago, and am facing a slight loss so far, but I’m holding on for now. I now also initiated a short Treasuries position, via TBT. Using levered ETF’s is not my favorite because of the daily compounding effects which we’ve spoken about before. However, they also often provide a cheap, easy implementation tool, which is how I view them here. All these positions are relatively small (less than 3%). This is not a recommendation in any way, but just wanted to keep you posted. For the record, my position was initiated late in the day (purchased TBT at 46.03).

We are also working with our tech group on constantly offering new improvements to the site. We are working with tech people and our compliance group to see how to show a portfolio, tracking trades, ideas, etc. so be on the lookout in the next couple of weeks.

This Time It’s Different

Not so happy, but important reading. Take this with you on the train, or read this on a plane. It is important!!

“This Time is Different: A Panoramic View of Eight Centuries of Financial Crises” by Reinhart and Rogoff give us a historical context (300+ years) to analyze the current state of currency, banking, debt and defaults, etc. By looking at a much broader data set, they provide a view into the common themes across periods that has implications for our future path (if you believe that there is some predictive value in history, which, as a value-biased investor, I do).  The paper is 124 pages, which might be a bit technical for most readers, but here is the quick abstract:

This paper offers a “panoramic” analysis of the history of financial crises dating
from England’s fourteenth-century default to the current United States sub-prime financial
crisis. Our study is based on a new dataset that spans all regions. It incorporates a number
of important credit episodes seldom covered in the literature, including for example,
defaults and restructurings in India and China. As the first paper employing this data, our
aim is to illustrate some of the broad insights that can be gleaned from such a sweeping
historical database. We find that serial default is a nearly universal phenomenon as
countries struggle to transform themselves from emerging markets to advanced economies.
Major default episodes are typically spaced some years (or decades) apart, creating an
illusion that “this time is different” among policymakers and investors. A recent example
of the “this time is different” syndrome is the false belief that domestic debt is a novel
feature of the modern financial landscape. We also confirm that crises frequently emanate
from the financial centers with transmission through interest rate shocks and commodity
price collapses. Thus, the recent US sub-prime financial crisis is hardly unique. Our data
also documents other crises that often accompany default: including inflation, exchange
rate crashes, banking crises, and currency debasements.

For the full paper click here.

The conclusions aren’t pretty, but they are informative and it should give pause to the emerging markets chasers, the sovereign debt buyers, and the currency speculators on all sides.

Andy Xie on China and USD

China bubble, USD, Chinese real estate, speculation, hot money… except not in the direction you’d expect. Xie outlines how China might go bust if the USD bottoms, and how the Chinese government has no choice but to continue inflating their own bubble – a very scary prospect. he believes it won’t happen for a few years; I’m not as confident.

http://www.businessinsider.com/andy-xie-china-is-trying-to-prolong-the-bubble-2009-12

Notes from underground – Yra Harris

Europe can’t cope with USD

Sarkozy came out with comments criticizing the weak dollar policies of the US. Of course Europe can’t cope with a relatively strong USD (http://www.hihifrds.com/hihifrds/news-and-content-updates/sarkozy-says-europe-cannot-cope-with-weak-dlr). Europe is facing it’s own debt deflation spiral and with individual countries unable to control their monetary policy, the results are a broken system. As we posted before, Dubai is just the first taste. Look out for Greece and Spain.

Notes from underground – Yra Harris

If you can keep your head when all about you

are losing theirs and blaming it on you;

If you can trust yourself when all men doubt you

but make allowance for their doubting too;

Some additional thoughts on Dubai World

Assuming UAE has $600-$700 bilion SWF (controlled by AD b/c most of contributions are from AD).  $80 Billion total nominal, buyout at 50% = $40Billion = ~7%.

$40 billion in one position is very big and I don’t think anyone wants to make it except because of pressure from their neighbors.

I see 2 options:

Option 1: this is a big deal. That means middle eastern debt becomes cheaper, CDS spreads go through the roof for all the neighbors, including Saudis. Some hedge funds and real estate funds must be blowing up right now. Next up, European banks get hosed. Can these guys do anything right? Madoff, private equity gone awry, CDO’s, etc. Swiss banks can’t even give you privacy any more. Money starts going home and this becomes a battle of flows. Anyone who is levered on the carry trade gets “FUBAR”ed. Beneficiaries: yen, dollar, gold. Biggest losers: emerging markets, anyone levered, European banks, and more. Marginal EU players start getting kicked out, like Greece. Euro begs Turkey to come in, and Turkey blesses Alah for unanswered prayers. Geopolitics start getting dicy: watch for Greece putting the heat on Cyprus to use it as a bargaining chip in its negotiation to stay in the EU. Turkey talks bigger and stronger against northern Iraqi kurds in hopes of US concessions and no fear of repercussions from EU.

Option 2: this is not a big deal. LTCM style, some back door deals brush it under the rug, with a global concerted effort. Fed is afraid of strengthening dollar undermining their inflationary push. In 2 weeks, no one remembers it, relevering goes exponential and the final stages of an asset re-bubbling are in place. China goes in and puts in a bunch of unwanted dollars to secure oil rights from UAE and neighbors for the next 20 years at $55/b. Buffett buys a piece of the debt at 30 cents on the dollar. Equity markets shoot higher, along with commodities. This could last for another 6 months to a year, at which point, we go where we need to go anyway, but a lot more people and money gets hurt.

The strategists and game theoreticians are going nuts right now, trying to figure out how to use this to put pressure on everything from Iran nukes, China, Afghanistan/Iraq, and umpteen others.

Connect the dots: Dubai World, China, USD, Yen, Deflation, and Bernanke

So Dubai World, the government investment vehicle (is that sovereign wealth fund?) is unable to make payments on $59 billion of debt. Please tell me you are not surprised! Command economies run by bureaucrats are always doomed. Investment vehicles run by same governments are doomed. I have no problem taking the other side of a trade from any SWF. Why? Because they are usually wrong. Some in the media are calling this a black swan event. Having kamikaze planes hit buildings in New York and DC is a black swan event. Having a debt laden government default is not.

For the past few weeks, I have been pointing out to readers my logic behind buying dollars. I did not know when or what would happen that would cause a flight to the dollar, but when so many people agreed that the dollar was going down, and when so many governments were discussing selling their dollar holdings, and when the dollar was down against every currency imaginable, there just didn’t seem to be anyone left to buy it: so I had to take that trade. I really dislike being on the same side of the trade as everyone else.

So what now? Well, the deterioration of the Euro will continue and GBP will be right alongside, maybe even beating it on the way down. China: I never liked China, and I still don’t like China (http://dyn.politico.com/printstory.cfm?uuid=DAB3DF2E-18FE-70B2-A8C736A21C10553A). If you want to play the space, go with Korea or Taiwan instead. I continue to favor India and Brazil (as long as they don’t get too involved in currency controls) long, long term over most other emerging countries. Japanese Yen: this is a tough one. Money will be flowing in as risk trades are unwound, but the government doesn’t want a rising currency, so they’ll have to step in. Overall, I believe they’ll be able to sell it faster than the US government can devalue the dollar, so that’s where I stand. What about the Fed and Treasury? They are in panic mode. All their efforts at quantitative easing have been for naught. People don’t want to spend. Banks can’t lend. The dollar will go up (at least for now) and that means deflationary forces with no tools left to pump money into the system. Krugman was wrong and I now wish we had the money we spent so hastily to support non-sensical businesses, like GM and AIG. Housing, contrary to popular opinion, is not going up. This is the time where the people who have cash will want to keep it for the really good deals that will be coming, but they’re not here yet.

In May, I wrote about what will be the signs that the worse is over (http://thehardtrade.com/archives/3150): employment, real estate, tough words and actions on the foreign policy side, and addressing transfer payments. With this as our rubric, employment not stabilizing yet, real estate not stabilizing yet, no tough words or actions to stand up to Europe or China (can Obama please say something tough to Hu just once??), and transfer payments are not only NOT being addressed, they are being exacerbated with misguided bills on healthcare. So we wait.

Notes from underground – Yra Harris

Not comfortable going into the weekend

Japan back in deflation mode (http://www.ft.com/cms/s/0/44fea966-d59c-11de-b80f-00144feabdc0.html), USD unstable, weak government officials who will need to make bold statements over the weekend, yields going negative (but everyone saying don’t worry)…this doesn’t smell right. Problem is, if you’re not already positioned, it will be tough to do in the next 12 minutes. But the currency markets are the ones I’ll be watching especially closely this weekend.

Notes from underground – Yra Harris

OK, I’ll say it, I don’t completely agree with Richard Russell

Here are some excerpts from Russell’s latest commentary. I’ll start with the parts with which I agree.

…Clearly [based on an earlier quote] Buffet is expecting inflation in the years ahead. I just received the latest “Insight” report from my brilliant friend, A. Gary Shilling. The report is entitled, “Investment Strategies In An Era of Slow Growth and Deflation.” Gary is convinced that the trend ahead is deflation. Buffett or Shilling, who are we to believe? No wonder the stock market is so erratic with the Dow up 100 points one day and down 100 points the next.

I agree. Inflation and deflation are slugging it out and so far, both are winning and both losing. The long end of the curve is pricing in deflation, expecting rates to stay low, growth to be anemic at best, and depreciation in all classes of assets, from residential and commercial real estate to equities to art. Simultaneously, inflation is winning, with the dollar being used as a cheap currency to buy anything and everything: Brazil, equities, gold.

Russell continues…

…OK, then how about this? You can take the phoney money that the Fed creates and you can actually buy something real with it. That “real something” can be gold or it can be a foreclosed home or it can be top-grade stocks like the thirty stocks that make up the Dow. Trade Fed-created junk for something real? Why not, it certainly makes a lot of sense.

This is the essence of the carry trade and I’m definitely not sure that it makes sense on any fundamental basis. In fact, in a few paragraphs Russell highlights how there’s a big disconnect between the financial and real economies right now, yet he still favors owning these irrationally priced assets. Hmmm.

But there’s something else. Sophisticated investors are beginning to distrust ALL fiat or central bank-created “money.” Moreover, they distrust a situation where central banks all over the world are creating huge additional amounts of their phoney money. Knowledgeable investors are starting to place all fiat money into a single class. And they distrust that class. They distrust it because they think of it as “junk money gone wild.” Their reaction — turn in your junk money for the one type of intrinsic money that has represented wealth for 6000 years — gold.

He’s right. A lot of sophisticated investors are turning to gold, but that doesn’t mean that they are right nor that there are fundamental reasons to buy it here.

…The other situation I’ve been thinking about is where the greater safety lies, in gold or in stocks. In his column in today’s New York Times, Paul Krugman calls what we’re going through the “greatest collapse in world trade in history.” Ordinarily, that would call for a bear market in stocks. But the enormous expansion in liquidity has trumped the fundamentals. The Dow continues to rise — as an ocean of money is flowing into the stock market. The rising Dow rubs off on other stocks as they start to look “cheap” compared with the stocks in the Dow.

But the fundamentals in the economy are leaving big holes in the bull arguments. Can a nation be prosperous when millions of its citizens can’t find jobs? Can a nation be prosperous when it can only sell the world (exports) when its currency is weak? Can a nation be prosperous when it’s losing its manufacturing base? Can a nation be prosperous when there’s a disconnect between its stock market and its economy? Can corporations be doing well when their so-called profits are higher but their revenues are lower?

I fully agree with this sentiment. In an economy with decreasing trade, decreasing manufacturing, rising unemployment, decreasing velocity of money, and all the other things he mentions, where does he see inflationary pressures coming from? There is a disconnect in the argument and in the arguments I’ve heard from every inflation-monger.

But remember, in this business we don’t buy fundamentals or logic, we buy direction and the flow of funds.

I do not. I do not try to catch the train, and if anything, often find myself in unpopular trades. In fact, not too long ago, I discussed here my initiation of the short Euro and short Yen trade vs. the Dollar. I will be looking to add to it. Russell has been around a long time and I really admire his insight, but there is too much riding on the inflation trade that I can’t get comfortable with.

Some here have spoken of “deflation in wants and inflation in needs”. I thought about that recently, and think that as unemployment or fear of unemployment rises to 13% or higher, consumers will reign in the spending, go out less, etc. and in the process, buy less of everything or just buy cheaper versions. Additionally, there will be one other great deflationary pressure: the dollar can go up. For those of us who like the contrarian trade, or at least believe in a reversion to the mean, what would you rather own: an asset that has gone up about 300% or one that is down about 40% in the last 10 years? Just some food for thought.

Notes from underground – Yra Harris