Treasuries

On Friday, into the close of the market, with no debt deal in site, treasury yields fell as prices rose with seemingly superhuman strength. You might be wondering, "Why on earth would prices rise as default risk increases and the US's credit rating is threatened?" Good question - I'm sure a lot of people who were shorting the 10 year into the weekend were thinking the same thing. Here's the analysis from Brad DeLong:

Yes, it is insane.

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Yields

Slowly and quietly spreads of the 2-10 year treasuries decided not to blow out and instead have started coming back.Viewing the remainder of this article requires a Subscription

Yields

The drama in yields is fascinating to watch, and at least in my own small way participate. If you haven’t, check out Bill Gross’s continuing missive on why to short long dated treasuries (http://tiny.cc/hxv6o) – the basic gist is that treasuries offer a low return/high risk investment and you’d be better off putting your money elsewhere. In the meantime, 2-30 spreads are blowing out as the yield curve is steeper than it has been in memory and the only think keeping rates low by historical standards is the continuing propping up of prices by the Fed, which is not the largest holder of treasuries.

In the meantime, I’m happy to be short treasuries, but I can’t say that it will be a real winner in the short term. While inflationary fears are running wild, with sugar, cotton, wheat, and all of agriculture hitting new highs, I am not confident that it’s not a speculative move that will end with new entrants getting burned. I’m not jumping in. I’m still maintaining my exposure to precious metals, and I still like energy, but the rest of the commodity space seems too risky for my investing discipline. If and when they come crashing, treasuries might have a last hurrah, which is why I’m not increasing my short treasuries position here. Just maintaining.

In the meantime, for a good source on viewing the changes in the yield curve, you can start here: http://stockcharts.com/freecharts/yieldcurve.html.

Relevant ETFs: TBT, TLT, AGG, DBA, CORN, SGG, JJA

Look at the bond markets

Yields are rising – as predicted, and more importantly, the 10-30 spread is reverting. Check it out:

Why is that important? Well, for starters, look for refinancing to decrease, new loan applications (with a lag) will also feel the pinch, and banks holding treasuries for trading will have to take some losses at year end if this continues. But those are the sideshows.

Banks riding the steepest curve in recent memory will be hurt as the curve flattens. It’s also not flattening at lower levels, there is also a parallel shift upwards, as yields all along the curve rise. This would be expected in an inflationary period, and has it’s own problems associated with it, but while we are seeing inputs’ costs rising, those costs aren’t necessarily being passed down to the final consumers – how could they with 10% official unemployment? This is when we anticipate margin contraction to pressure earnings. We saw it with DF, then with KR, soon the restaurants will report the same. I’m looking for Chuck E’ Cheese to take it on the chin.

The extent of the problems grow from there. Borrowing costs on floating rate revolving lines of credit will increase. Working capital loans will be called in. And I anticipate that in the next couple of quarters China will start disappointing on the downside.

All from the curve.

10 year, and the 10/30 Spread

Just because I haven’t written about it in a few days, doesn’t mean I don’t look at it. And look you should.

Weekly 10 year yield, rising (as expected):

10/30 Weekly Spread, rising (as expected):

I think it won’t be a straight shot up, but rates are going to increase, as they do in debt deflation cycles. This, in turn, will put additional pressure on refinancing applications, new home purchases, etc. The one good piece of news out of this is that a flattening curve might encourage banks to lend to companies rather than the government since their NIM will start getting squeezed. I’m hopeful, but not confident that this will the result.

Equity markets behind the curve

I lost some faith in bond investors as yields got down to historic levels. I spoke out about it, but investors continued to believe that deflation leads to lower yields. Right about deflationary pressure, wrong about it leading to lower yields. In a ZIRP environment, after a credit bubble, we will see debt deflation lead the way lower in all major asset classes.

Check out the 10-year yield:

It’s almost a relief that it’s finally rising. It means bond investors are finally getting it – taking duration risk is not worth it when rates can’t go lower and the Fed’s policies become asymptotically ineffective. We have a long way to go before I start buying the dips on bonds.

Is anything down today? Oh yeah, our sanity.

If the Fed was targeting stock prices, which seems to be the case, then at least for the time being he was successful. So let’s review, in a situation where money is already dirt cheap but not lending is happening, the Federal Reserve decided to target stock prices (call it, asset prices in general to give it the benefit of the doubt) that are held by relatively few people. Hmmm.

Gold is close to an all time high and certainly at a 20 year high:

Meanwhile, the dollar is down, although not at it’s lowest point:

But it doesn’t matter where you look today, it seems like the reflation trade is back on, deflationists be damned. Except, the yield on the 10 year is going down. What gives?

This is the result of investors front-running the Fed purchases.

I hate sounding like a downer, and I hate that I keep beating the negativity drum, and I’m certainly not any perma-bear. But this is not sustainable, valuations are not where you’d expect for any long term decent return on investment, and any quantitatively driven excess returns will be met with a more serious downside impact that will show up in future returns, but more importantly show up in future standards of living. We will look back at this period with astonished incredulity at our own lack of foresight.

In 1999, a relatively few advisors and analysts were pointing out that valuations were unsustainable. Then we pointed out that accounting gimmicks, such as recognition of revenues, channel stuffing, etc. were unsustainable and only represented “borrowing” sales from the future. We now have the same two factors in play. In terms of the latter, we are borrowing from future consumption and GDP growth, but eventually we will need to pay it back. We see it on the macro and the micro level. Financial institutions are “borrowing” earnings from reserves, while on the macro front we are literally borrowing some GDP growth.

Could it be my own bias that is keeping me from fully participating in this rally? I’ve been examining whether my own stance has led me to a position that is difficult to back down from, and therefore all the analysis is skewed to confirm my hypothesis. The answer is – maybe. I say maybe because maybe we are in a new world, but I seriously doubt it. ZIRP might mean that stocks are undervalued, but I don’t think so. $600 Billion might stimulate job growth that will compensate for the cost of the program, but I doubt it. The Fed might be effective in reaching their goal of a weaker dollar, but I don’t have any faith that they can be effective in anything other than causing uncertainty. Japan’s currency might continuously get stronger, but I doubt it. China might grow endlessly and not have a real estate bubble, but, again, I don’t think so. No matter where I look at the underlying fundamentals and money flows, there are disconnects that will need to correct. Certainly, some big investors disagree with me, so it is not without hesitation that I take the other side of their trades. However, as a disciplined fact-based investor, I can’t allow myself to be dissuaded from the research – and for now, all signs point to trouble.

Waiting with bated breath…

It seems as if every market is at a critical juncture and just waiting with bated breath. Which ones? Well, there are the important ones: currencies and bonds. Equities aren’t on the list of important ones right now, because they are just following the moves in other markets. The trade has been short USD, long equities – a reflation trade. The 10/30 spread has been blowing up as rates on the long end jump and rates on 10 years and shorter have been locked down. Great if you want to start a bank, not great if you’re poor and milk prices are rising at the supermarket.

Let’s start with the USD:

If the USD bounces here, it will generate an unwinding process where equities will have to be sold. It will be a domino effect that will cause one big Wall Street margin call. I’m positioned for this scenario. Many, if not most, investors are positioned for the USD to continue falling, believing the Fed can re-inflate the economy and seeking safety in equity earnings that they believe will rise with inflation.

If the USD doesn’t bounce here, then we can get some inflationary pressures. Equities might benefit, but the real beneficiaries will be the commodities and related companies. DBA certainly looks strong and has had a very nice move recently:

DBA, while a follower of the currency moves, also has something else going for it: geopolitics. With some freak draughts and weather related incidents causing additional strain to the already tense political maneuvering, DBA could benefit from increased protectionism as countries move to protect their domestic supplies. It could provide a good support, but this, again, is a critical juncture.

Meanwhile, the 10/30 spread, while off it’s historic lows is still at incredibly low levels:

In the meantime, EEM is possibly rolling over. I say possibly, because it hasn’t broken it’s uptrend, but with continuous inflows on the one hand, but emerging economies trying to dissuade those same inflows on the other, it can go either way – depending on the market’s view on the USD.

And on and on we go. The financials have been significant underperformers this year, and at some point (I think in the very near future), the large hedge funds holding the financials might be squeezed out. They’ll have to either liquidate their positions in BAC, WFC and the like, or they’ll have to liquidate in other markets (gold? USD? treasuries?). And let’s be real – can the equity market have a sustainable rally without the banks? I think not.

Every market I track is waiting to see what happens with the USD. I have been calling for a reversal day for a while, but I think it’s coming (maybe today is the day), which will signify the need to unwind the risk trade. That unwinding will involve USD getting stronger, equities and commodities getting hit hard. The real problem with that scenario is that there will be no place to park and hide.

10 o’clock briefing

Markets are under pressure again. Dollar is holding up though and might have found a bottom.

In the meantime, banks continue to be under pressure from fraudclosuregate:

While the market awaits the Fed report on currency manipulation. This report will probably say nothing of substance, hope to put some shallow pressure on China, and leave it at that. But treasuries are selling off anyway with yield rising:

Elsewhere, oil is holding up remarkably well, GOOG is holding up the Nasdaq with a 10% gain after last nights earnings report, and consumer sentiment declined more than expected.

Let’s see if this is just profit taking or the beginning of the realignment we anticipate.

10 o’clock update

Looking around the markets it’s tough to discern fear from euphoria today.

Transports are running:

…while the bank index ($BKX) is lagging:

I’m hearing more and more people come out to describe a global inflection point, such as Marc Faber, but I don’t follow their logic entirely. Walk with me…

Interest rates are at a turning point and will start heading higher. Faber, and others, are recommending piling into stocks as the safe haven. I just don’t get it. Interest rates aren’t rising as a result of inflationary pressure. Incomes aren’t being pushed up, and earnings aren’t going to grow. Valuations such as q-ratio and Shiller P/E are showing equities to be 30-40% overvalued and even with printing, velocity of money has collapsed. During the last QE sessions, the US Fed pumped roughly $1.6 Trillion into the markets, without stimulating job growth, asset inflation, etc. So while I agree about interest rates rising, I am not convinced that equities are the place to park cash.

JPM reported and is heading lower – in an up market? Is this market move sustainable without the banks?

Meanwhile, even with additional fodder that the Fed will be supporting the treasury markets through QEII, and talk of targeting a 2% rate on the 10 year as a possible policy, the 10 year yield is rising. Sell the news?

10 year:30 year

Last week we discussed this ratio: 30 year yields were blowing up vs. 10 year yields, perhaps in anticipation of inflation, or who knows. This ratio seemed extended at the time, but might now make a comeback. Here’s the 10 year yield vs. the 30 year yield.

The 10 year yield has a long way to rise against the 30 year yield to come back to it’s longer term averages. The chart above is a weekly chart going back to late 2007.

You thought equities would sell the news…

Buy the rumor sell the news (of QEII) – at least that’s what the analysts were telling us this morning. Well, the Fed notes came out and QEII is on its way and somehow the desired policy is wagging the numbers rather than the other way around, so recession fears are lowered, growth tepid, but positive, etc.

But wait…someone out there is actually recognizing a problem? Could it be? Maybe, because while equities are up as I write this, the 10 year is down (yield up):

I’m not calling a top in bonds – I’ve been short for too long, but foreign holders might not be happy anymore with a weak currency and little yield. Something has to break further to bring some semblance of logic back, but this might be a start.

Lots of noise

I know the market feels like it’s gone up – a couple of up days, even on low volume, make everyone feel giddy inside. But let’s review where we are:

The S&P 500 has done a lot of moving without getting anywhere. It’s about where it was at the beginning of the year, which is roughly where it was in mid 2008 (and by the way, about where it was in 1998 for those keeping longer term track).

Meanwhile, the 10 year yield is roughly where it was in mid-2009:

On the other side of the Pacific, we’ve been looking at the yen for a long time. And yes, I told my readers that I went short in late 2009. Guess what…I’m still short and the yen is pretty much right were I got into my position. Not that I’m proud of a slightly down position, but the reasons to get into the trade haven’t changed and none of the factors that would get me out have been seen. Can it get stronger from here? Of course and I wouldn’t even be surprised.

But all of this talk of yen being a store of value misses the point of the fundamental challenges Japan is facing with no easy way out. Multiple people have recently recommended books like When Money Dies: the Nightmare of The Weimar Hyper-Inflation by Adam Fergusson and Dying of Money: Lessons of the Great German and American Inflations (see for example this recent article HT MacroMan). I’m not opposed to the possibility, but surely Japan is in much greater danger of the hyperinflation mentioned than the US.

But I digress, because the point of this posting was to mention that we have had a lot of noise. I can show other charts, from EEM to different currencies, but the themes are the same. I continue to look to fundamentals as the critical guides for valuation and long term opportunities, and at least in equities, valuations are expensive – so we wait.

10/30 spread

The 10/30 spread continues to signal something…

Namely, yield on the 30 year bonds are rising relative to the yield on 10 year bonds. Could be inflation fears. Could be fears of sovereign debt in general. Could be liquidation by banks needing to shore up short term reserves (maybe even European banks needing euro liquidity since euribor is rising).

Random Thoughts

• 7 year auction comes in at a low bid, but 10 years start selling off? How come?
• Hugh Hendry‘s wants to take Soros down and believes the euro is doomed because there’s a structural problem of maintain fiscal vs. monetary interests. He must be reading The Hard Trade site.
• If financials and energy and retail and tech are all heading lower, who’s left to lead a rally?
• Is the Baltic Dry Index spelling trouble for the CRB space? Does anyone even care that rail traffic is improving?
• Is SNB going to break with their ever-growing euro position? They’re setting themselves up for some trouble down the road – but then again, I’m short the euro.
• Gold continues to hold up as the vent, but silver might be the ultimate winner.
• I’ll admit it, I sometimes like to say “I told you so”. For months we’ve been telling our readers that real estate is not stable, that the numbers are being manipulated by government stimulus, and that the current crop of speculators will be crushed. So, it was with no surprise that the sales numbers came in so low. And we ain’t done – commercial real estate along with residential is still being mispriced on bank balance sheets (and on Freddie and Fannie balance sheets). We continue to stay away.