It makes me uneasy when too many people agree with me…

1. The End of the Bond Bull Market: Barry Ritholz writes in The Big Picture that the bond bull market we've been seeing since 1981 looks like it might be ending.

Is deflation winning out?

In the ongoing debate between inflation and deflation, we’ve heard both sides, tried to look to the historical record for guidance, sought comfort from statistics and experts, yet in the end have come up with strong arguments on all sides. We’re not even sure all the information is conflicting anymore, but in the end, we have to define and quantify a bias, a world view, a story that binds the different pieces together. We find ourselves continually biased towards deflation. It’s colored our decisions, and impacted our investments, and still we find ourselves now with seemingly conflicting investing ideas: short bonds and long metals sounds like it might be inflationary trades, underweight equity and long cash sound like they are deflationary trades. Underweight real estate, overweight India and zero weight to China – how do those all fit in? Are they hedges against each other? Compounding each other?

Let’s start with some basics. Deflation happens when an organization loses pricing power. It happens when organizations need to find lower market clearing prices. It can happen in positive ways (for example, by paying $500 for a laptop with the computing power that cost $5,000 a few short years ago) or negative ways (for example, when you’re house sells for 15% less than it did 3 years ago). It is initially painful to the seller, and especially painful to the levered seller. For the buyer, it feels great – initially. Until it doesn’t. At some point, the buyer decides that it’s worthwhile to wait longer for an even better deal. At some point after that, the buyer realizes that whatever product of service he/she is selling will probably also need to be discounted in order to clear, at which point a bit of fear sets in. And there’s the danger. On a more macro level – organizations that lose pricing power face a squeeze on margins. Those that are levered then face a squeeze on financing. On a more macro level – trade goes down, protectionism looks like a good idea, and then it’s over. At some point market clearing prices are reached, companies that survive with strong balance sheets regain pricing power, etc.

Why go through this exercise? Let’s think through the organizations we have to analyze: people, households, companies, governments. As we go through each organization, we find deflationary forces:

1. People – labor is not in control these days. Wages are stagnant, at best. Unemployment is at 10% and if you’re using good statistics, closer to 18%. If anything, wages will be put under pressure in the near future.
2. Households – continue to be indebted, even though many are trying to lower it. Residential real estate has been nationalized, with 95% of new mortgage originations occurring through GSE’s. Real estate has not stabilized, and commercial real estate is about to roll over.
3. Companies – retails has actually held up better than expected, but credit card defaults are rising and the consumer will require more and more sales (deflation) to purchase. Internal demand from Asia hasn’t materialize (yet). Most importantly, margins have risen to such high levels off the back of squeezing costs. Margins going forward will be tough without an increase in revenues, which hasn’t come.
4. Governments – governments can lose pricing power as well. Japan has been a startling anomaly, but I wouldn’t depend on it continuing or working for others. With debt to GDP starting to hit important levels, government bonds will lose their appeal, and with it, their pricing power. So, prices will have to go on sale. We’re seeing it already in the municipal bond market. We’re seeing it with sovereigns like Greece. We’ll see it with Treasuries as well. If the US government loses pricing power, won’t the dollar fall as well? Actually, it might not. The dollar will still be needed for trade, for a safe haven, and as a relative trade against the worse government situations in Japan and Europe, so we can have a situation where the dollar is up and the Treasuries are down.

All of these organizations seem to me to point to a contraction of margins on all fronts, loss of pricing power, consolidation, retrenchment, and balance sheet rewinds to the pre-”stock option/insanely low interest rate/agency-moral hazard games of manager vs. owner/etc.” times.

We continue to mistrust rallies at these valuations, and are wary of people screaming to buy the dips.

Notes from underground – Yra Harris

A lot of STUFF is flying around

Gold – still hasn’t found its footing.

USD – definitely found some footing. Who wants to go short the dollar long risk into this weekend? No one.

Sovereigns – I heard one analyst talk about where there’s one roach (Dubai, Greece) there are probably others (Ukraine?, Ireland?, Spain?, Latvia?, Some country in South America?).

China – Industrial numbers came in about 1% better than expected, but I don’t thing the market cares. Currencies are the order of the day.

Banks – After their massive, Fed induced rally, I still can’t stand them. It’s all accounting games, Bernanke (and now Geithner) puts, and I don’t see how they’ll make money without transactions and the coming reigning in of leverage. Their business models now depend on NIM, which I think will soon be threatened. Also, we noted last week that there might be somewhat good news for CME as it stands to benefit from moving the CDS market onto exchanges. Turns out it’s also another negative for the banks as they stand to lose a few billion dollars in revenue (http://www.ifre.com/story.asp?sectioncode=730&storycode=318015). I have no position either way as of this writing, but I’m definitely not going long here. Good luck to John Paulson with the Citi offering on tap.

Stay tuned for an interesting weekend.

Russia to buy Canadian dollars

This is some of the stuff out there these days. Yes they’ll buy a little CDN and yes the dollar continues to be under pressure, but isn’t it a bit a a leverage play for Russia, after all, it’s one resource currency buying another. If anything, they might want to hedge with an increase in dollars. As readers already know, I’m on the other side of the Russian traders holding on to my small short Yen and Euro position. It’s small, and it’s the holidays, so the thin markets can go all over without me losing too much of my tofurkey.

http://bloomberg.com/apps/news?pid=20601087&sid=at5XsdLU.68w&pos=6

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

Mother of all carry trades faces an inevitable bust

This was recently posted by Nouriel Roubini. I’m posting it here, with the knowledge that I am exhibiting some serious confirmatory bias, since I shorted the Yen and Euro last week, and discussed how the short dollar trade is beyond crowded. Roubini points to the dollar being the funding currency of choice due to the incredibly favorable carry from the depreciating currency. He goes on to state that this will not last forever and that it is fueling a world-wide bubble, which I agree with wholeheartedly. The questions are when will it realign, how painful will it be, and how can we position portfolios appropriately. When, how big, and where…the three elements of a useful prediction.

Mother of all carry trades faces an inevitable bust

By Nouriel Roubini

Published: November 1 2009 18:44 | Last updated: November 1 2009 18:44

Since March there has been a massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply , while government bond yields have gently increased but stayed low and stable.

This recovery in risky assets is in part driven by better economic fundamentals. We avoided a near depression and financial sector meltdown with a massive monetary, fiscal stimulus and bank bail-outs. Whether the recovery is V-shaped, as consensus believes, or U-shaped and anaemic as I have argued, asset prices should be moving gradually higher.

But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage-backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

While this policy feeds the global asset bubble it is also feeding a new US asset bubble. Easy money, quantitative easing, credit easing and massive inflows of capital into the US via an accumulation of forex reserves by foreign central banks makes US fiscal deficits easier to fund and feeds the US equity and credit bubble. Finally, a weak dollar is good for US equities as it may lead to higher growth and makes the foreign currency profits of US corporations abroad greater in dollar terms.

The reckless US policy that is feeding these carry trades is forcing other countries to follow its easy monetary policy. Near-zero policy rates and quantitative easing were already in place in the UK, eurozone, Japan, Sweden and other advanced economies, but the dollar weakness is making this global monetary easing worse. Central banks in Asia and Latin America are worried about dollar weakness and are aggressively intervening to stop excessive currency appreciation. This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. So the perfectly correlated bubble across all global asset classes gets bigger by the day.

But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

The writer is a professor at New York University’s Stern School of Business and chairman of Roubini Global Economics

Notes from underground – Yra Harris

Value Investors Congress: David Einhorn speech

If you haven’t already seen this speech, it’s a must read. David Einhorn walk the reader through a failed government intervention, a dangerous Wall Street-Washington complex, and the challenges for fiat currencies globally. He’s not an alarmist on either side of the inflation-deflation debate, but rather, point to the fact that gold can be a store of value in inflationary periods (1960’s-1970’s) and deflationary (1930’s), and is generally a hedge against bad government. For the full speech, click here.

Is DXY going to bottom soon?

Check out the chart of DXY. I don’t gravitate towards technical analysis, but I do believe that looking at a chart can help summarize history. As I look at this months, I can’t help but feel that DXY won’t continue its downward trend. For starters, I don’t think the Euro nor Yen are looking that healthy from a monetary or fiscal perspective. Then there is the issue of everyone being short the dollar, which can’t continue. So I just shorted the yen and euro. This is not a recommendation for you to follow suit, and I’ve been wrong about the timing of currency trades before, but at these levels, I can certainly withstand some pain to see whether it plays out in the medium term.

Niall Ferguson: Dollar may drop another 20%…

This came out earlier today. I’m not saying I disagree, I’m just not convinced it’s easy to know “against what”. The euro? Why? Fundamentally, the other currencies in the world don’t seem that appetizing to me, especially at these levels. Now, if you said drop 20% against specific commodities, then it’s a definite maybe, but at least we can discuss the underlying supply/demand issues. Against the Euro? They are in worse shape than we are, they just don’t understand it yet. The Chinese yuan? They’ve been keeping it artificially low for decades just to get a little export going. Do you think they can afford to let it drop 20% from here? Doubtful, or there will be mutiny on the Chinese seas.

Enjoy…

(By the way, I like Ferguson a lot and try to pick up anything he writes. Phenomenal writings on history, history of economics, and tying everything to the geopolitical landscape.)

Dollar May Drop 20% More on Deficit, Harvard’s Ferguson Says

By Cordell Eddings and Thomas R. Keene

Oct. 16 (Bloomberg) — The dollar will extend its drop versus the euro over the next two to five years, falling as much as 20 percent to an all-time low under a widening U.S. budget deficit, Harvard University’s Professor Niall Ferguson said.

Policy makers favor the dollar’s slide as a means of supporting a recovery from the worst economic slump since the Great Depression even as they voice support for a strong greenback, Ferguson said in an interview on Bloomberg Radio.

A weak dollar is “the simplest solution to most of America’s problems right now,” said Ferguson, author of “The Ascent of Money: A Financial History of the World.” “We are likely to see 1 percent to 2 percent growth unless exports take off, and that’s what everyone in Washington is quietly hoping: If the dollar keeps sliding, then maybe we can get some traction on exports.”

The dollar increased 0.4 percent to $1.4887 versus the euro today after depreciating yesterday to $1.4968, the weakest level in 14 months. The U.S. currency touched $1.6038 on July 15, 2008, the weakest since the euro’s 1999 debut.

The world’s largest economy shrank at a 0.7 percent annual rate in the second quarter, the Commerce Department reported last month. Gross domestic product contracted at a 6.4 percent pace in the first three months of 2009.

Economists forecast the current-account deficit will rise to 3.2 percent of gross domestic product in 2010 and 3.3 percent in 2011, compared with 2.9 percent this year.

‘Terrible News’

The weakening of the dollar is “terrible news for practically all of the rest of the world’s economies,” except the U.S. and China, said Ferguson. China, which manages the yuan’s appreciation, will “intervene to make sure the dollar does not weaken” relative to its currency, Ferguson added.

Treasury Secretary Timothy Geithner said on Oct. 3 after attending a meeting of Group of Seven finance officials that it’s “very important” for the U.S. to have a strong dollar.

The administration of President Barack Obama pushed the nation’s marketable debt to an unprecedented $6.78 trillion in an effort to spur economic growth and support the financial system. The U.S. government ended its 2009 fiscal year with a deficit of $1.4 trillion, the biggest since 1945, the Congressional Budget Office reported.

The currency market rules the day

The currency markets have always been bellweathers. Parity, relative valuations, interest rate policies, monetary shenanigans, etc. all influence the prices. With that knowledge in mind, what are the current markets telling us.

1. Global hyperinflation is NOT on the horizon. How do I know? For starters, gold is going up, but only in terms of the dollar. Versus the other major currencies, it’s actually barely a blip.
2. US Treasuries are not crashing. Maybe its a not crashing yet, but for now, they aren’t. Yield continue to be extremely low by historical standards. Whether its support from the Fed buying up GSE bonds to keep mortgages low, or US investors parking in short term bills, even the 10-year yield is staying low.
3. The dollar is going down, but pretty orderly. No mass panic (again, maybe just a matter of time) and for all the talk of using different currencies or baskets, nothing matches the depth and liquidity of the dollar at this stage.

And it goes on. For a good summary of where we are and our best case scenario, check out Andy Xie’s piece today: http://english.caijing.com.cn/2009-10-12/110279505.html. His underlying premise is that the best-case scenario is mild stagflation, with low rates, inflation of 4-5% but contained, and slow, yet steady, deleveraging.

While this might sound like a rosy scenario, I’m wary of how likely it is. For starters, everyone has to be on board, including investors who would willingly take return-free risk with US Treasuries. An unlikely scenario since we are not in war conditions, where the emotional and patriotic kick in. Second, international investors won’t stand for it if their local governments start tightening (e.g. Australia). Lastly, our biggest buyer, the Chinese is facing its own slowdown, and will need to use up reserves to stimulate.

So where does that leave us? I keep writing about a disconnect: Why would the dollar keep going down, yet Treasury prices stay stable? Why would the dollar go down against currencies with many more problems on the horizon (i.e. Euro zone – everything from demographics to social policies)? Why would people selling the dollar lead to ever higher equity prices? The currency markets are the places to watch right now, and I believe they are sending mixed signals. I’m not buying the end of the dollar story, and I think that trades crowded. It doesn’t mean it can’t/won’t go lower, but it will do so without me.

Dollar, Gold, and Oil and, oh yeah, Australia

So many things happened overnight that it’s tough to recognize that each one on it’s own is such a big deal.

For starters, the UK Independent ran a story that has everyone talking: http://www.independent.co.uk/news/business/news/the-demise-of-the-dollar-1798175.html. In the article, Robert Fisk writes that the oil producing countries, along with Russia, France, and China are secretly planning on NOT pricing oil, and presumably other commodities, in dollars. this has obvious negative implications for the USD. For starters, who’s going to want to hold on to their dollars or dollar-denominated Treasuries? China could stop purchasing our debt or even sell off the trillion dollars it owns already. But why? Why would China, instead of assisting the other nations, not just continue to use it’s dollar hoard to buy up commodity and natural resources companies around the world? Kuwait and the Arab nations as well. What does this move portend? The story might be true, but I’m just not sure I understand the motivation behind it at this point, when the dollar is already so weak.

Then, to top it off, Australia raised it’s key lending rate. http://www.marketwatch.com/story/australia-first-among-g20-nations-to-hikes-rates-2009-10-06. In a surprise move, the Australian central bank raised its key rate to 3.25% (from 3%). Well, someone had to do it first. I had wild hopes that Bernanke and Obama would be the ones to start, but no luck. Raising first gives the country a little breathing room, a first mover advantage, and a chance to lower in a couple of months when/if things turn out to be as bad as I fear. Good move, Australia.

In the meantime, Conde Nast is closing 4 titles, Christmas sales estimates came out at down 1% from last year, and the markets world wide are moving up in lock-step. I’m not buying it. There is some massive disconnect occurring. US dollar losing its primacy would add to instability (in my mind) at least in the short term, economic fundamentals are not positive (they are mixed at best, although unemployment is definitely negative), geopolitics are mixed at best (very negative in my mind, but I’m probably biased), and healthcare is going down the tubes. Maybe it’s so much negative news that it’s all priced in. Yes, maybe. Or maybe everyone is getting ahead of themselves.