Spain’s banks need to be recapitalized

Reuters is reporting that Spanish banks need an injection of roughly $27 billion in the next seven months or risk at least partial nationalization.

Concerns that Spain’s savings banks, which account for 50 percent of the financial system, will require an expensive bailout have weighed on the country’s sovereign debt and fueled fears it will need an EU/IMF-backed bailout like Ireland.

“The government considers it necessary to take a number of measures to dispel any doubt over the solvency of our credit entities and their ability to withstand shocks even under the most adverse scenarios, and so ease their access to capital markets,” Salgado said during a news conference.

In a move to restore market confidence, Salgado announced a regulatory overhaul of the banking sector, obliging all banks to boost core capital ratios to a new minimum of 8 percent by September.

Read the full article at http://www.reuters.com/article/idUSLDE70N1M020110124.

Remind me again why the euro is rising? Is the Fed printing so much relative to Europe that the USD is getting weaker? Is it anticipation of QE3? Quite honestly, I don’t get it, and I can’t help think that this is a suckers rally, because the structural issues remain, the bad debt overhang remains, and the social unrest remain. I expect the euro to resume its downward drift shortly. Maybe it will head to 1.40 range first, but I don’t think it will approach the highs at 1.50. Which means it has about 5-10% upside, but at least 20% downside risk. Working out the probability of each and I come out to a negative (significantly negative in my eyes) expected return from any long exposure to the euro at these levels.

In another view, gold, priced in euro has pulled back recently, and with talk of a general pullback in gold that position faces some downside risk. Heavy traders can take position to play the swings, but for investors and core positions, I’m still long gold:euro and think it represents a safe haven trade as euro investors will soon look for preservation against their internal wealth destruction.

Relevant positions/ETFs: EUO, FXE, GLD

Competitive devaluation will not end well…

Just a link this time: http://www.businessinsider.com/brazil-currency-intervention-2010-9

Inflation stories starting to surface

Deflation has been all the rage the past few month as bond prices continue to astound bringing yields down, and analysts like David Rosenberg at Gluskin Scheff turn out to have been right. And, I admit, I too have been in the deflation camp, arguing that a global slowdown, and a Chinese slowdown especially, will cap any upward price pressures. I’m still in that camp, but not as adamant as I used to be. There are a few major trends on the horizon that are starting to tilt me to the other camp.

The first is structural. Globally, governments are all in stimulative mode, trying to outdo each other on the easing fronts. Japan is the classic story of the government continually being thwarted with higher yen, but if there’s one thing a government can do effectively is devalue the currency, so I expect the government to eventually win. But Japan is not alone. Ireland is issuing debt to itself, in an apparent twist on the ponzi scheme – in the Irish version, they’re actually pyramid-ing themselves, without bringing in new investors. Hmmm. Probably not going to work out well for them. The US too is in easing mode, which will eventually mean yields will rise. So, while I’m not in the inflation scare camp yet, global easing continues to make me fear fiat currencies.

Then, there are the stories, apparently unrelated, but sounding incredibly similar. Coffee prices up by a third in the past few months as reported by the WSJ. How about Russia banning exports of wheat, sending the prices higher? What about gold hitting new highs? Check out the corn ETF:

True, energy hasn’t skyrocketed, but it also hasn’t broken down in the face of global slowdown. How about POT getting Chinese interest? Or the increase in rare earth materials? For now, a lot of these prices moves are supply disruptions and not being driven by demand, but could they lead to an increase in consumer prices and a flight to “needs” in the near future? Very possibly and it’s something to keep an eye on. For now, economic slowdown and consumer retrenchment are the orders of the day, as is debt deflation (coming soon) on the corporate and sovereign sides, and depressed equity valuations. But at least on a relative basis, if not on an absolute basis, the recent moves in the above mentioned markets might give us insight into where to invest.

Random thoughts mid-morning

• Consumer sentiment plunges – surprised? If so, then you’ve been living in a cave. Of course it’s down.
• CPI is flat (ex-food and energy) to down (slightly). Gives the Fed breathing room for QEII if they need it, except the dollar is weakening anyway in different pairs, most notably…
• Yen!!! Someone is squeezing the shorts in yen and BOJ isn’t stepping in (yet?) to fight them. Is China buying it up? Is this just a massive unwind? I don’t know, but something here doesn’t smell right. The yen is one of the fundamentally weakest currencies.
• Financials are taking it on the chin, and rightfully so. The market is recognizing the games these companies are playing. In a normal market, these accounting moves would border on fraud, except that the government either has a stake in them, or is afraid to move against them. Either way, I’m staying away.
• GS – of course they settled. The Obama administration thought first that demonizing GS would help them look tough on investment banks. When the markets turned south, the administration thought that a settlement would help lead the market higher. In both cases, they got it wrong.
• This is the time to be a challenger as every seat at every level of government is up for grabs. Doesn’t matter what side of the aisle you’re on – if you’ve been in office during the past 2 years, your seat is up for grabs.
• Iran. North Korea. Geopolitics in general. Just to quiet for me to feel safe. I’m a city guy, so I feel safe with noise. The summer quiet time on the global scene is not conducive to my sleep.

Holding positions requires understanding yourself

Since we last checked in with readers, the euro has moved up to 1.27 and I’m still short – what gives? Well, for starters, since I’m not a trader, I’ve had the position on since late 2009, without changing it, without trading around it, without even considering closing it – even when it was going against me. Why? Traders are always looking for a “move”, a “trade-able bounce”, or whatever where the can move in and out for a relatively quick, relatively small profit. There’s definitely money to be made in those strategies if done in a disciplines manner. Because positions are closed out quickly, financing is more flexible for trades, sharp ratios can be pumped up, etc.

My strategy of investing, based primarily on underlying fundamentals and looking for value across asset classes, takes a lot of time before any security is purchased. There is a lot of waiting before entering a position and before exiting. Much like a farmer, my team and I watch indicators, valuation levels, and correlations; we read about history; we read psychology books; we play around with Excel models; we brainstorm about major themes and global trends; mostly, we argue and doubt. Since it takes us so long to enter a position, it usually takes us a long time before we exit. Exiting a position rarely happens based on stop-loss levels or if a position is profitable or not. Rather, exiting depends on why we entered the trade to begin with. For example, if we put on a short euro position due to various indicators including sentiment, valuation models, flow of funds, and academic research on the foundations for a stable currency (the euro’s prospects based on this last one don’t look particularly good), then in order for us to exit, some or all of those factors would need to change. If we buy a stock based on undervalued fundamentals, then we would only sell it once either it became overvalued or the factors that led to its undervaluation change (like earnings do not recover as expected).

Since I believe that none of the fundamental short factors have changed for the euro, I’m staying short. Not adding, not taking profits off – just maintaining my position. After all, it took me so long to get in, I’d hate to lose my entry now.

And right on queue: Transports (IYT)

We’ve been discussing the different underlying messages the market is saying, but recently, a lot of the messages have been quite clear:

• We have real estate rolling over as seen through housing numbers. Any uptick in commercial real estate seems like a last gasp as…
• ECRI leading indicators are rolling over. Recession schmecession – it doesn’t matter what you want to call it, but without jobs in the US, there is no growth in consumer spending. We’ll have periodic upticks as built up demand vents in certain weeks or months, but the consumer is retrenching. Now you might have expected all the global stimulus funds to keep the party going for a while longer, but…
• Europe is starting their austerity program. Guess what, they are so structurally flawed that even THAT doesn’t help the euro. However, it will lead to a slowdown in growth in the eurozone, which wouldn’t be that significant, except…
• Europe is China’s biggest export destination. So you’d think the Chinese would just let things be, but instead, they’re tapping on their brakes and NOW decide to make statements about revaluing the yuan? Aside from a political grandstand to show how weak they believe the Obama administration to be, this is probably cutting your nose to spite your face, because they’ll be doubly hurt when…
• US growth slows along with Europe’s and China’s internal markets prove to be fake. Why? As I’ve mentioned before…because THEY”RE COMMUNISTS! Still, the markets looked like they might like the news, except, the rally quickly faded yesterday and today. Throughout, it was pretty surprising that the Dow Transports were holding up…
• And still are, by most measures. But our goal is to move forward and today’s 3.75% might be a harbinger of what’s to come:

  

• So that leaves us with AAPL. What a company?! What a stock?! Can it last? Me thinks not.

Yuan all around

Everyone is talking about it, parsing it, and (for now) praising it – but why?

By theoretically lifting the dollar peg (ever-so-slightly) the Chinese have pulled off a strategic political feat. First, they take pressure off themselves as world politicians try to find a scapegoat for their own economic mishandling. Second, they tap the breaks on their own credit induced real estate mania. Third, they give themselves a way out of increasing their treasury holdings.

And there you have it. By devaluing the yen, even a little bit, they open the window to slowing their treasury purchases. At the same time, since the Chinese don’t buy as many goods from the US as the US consumer buys from China, they don’t really risk any increase in domestic prices of US goods. On the other hand, the US consumer might face higher prices from Chinese goods, namely, everything. So the US trade deficit might get better from the fact that imports will go down, but I do not anticipate exports to China to rise substantially. Turns out that the Chinese don’t want to buy anything we produce – including our debt.

So what now? We remain short treasuries. The uptick in equities seems absurd since the cost of capital is rising, China is tapping their economic breaks, and US consumers will buy fewer goods in general (since Chinese manufacturing costs will rise). Not sure where the positive outlook for stocks is coming from, but alas, its there for now.

China manipulating Euro?

I’m hearing it from all over the place that China is stepping in to stabilize euro. So let’s see, your biggest trading partner and export markets are seeing their currency devalued and they are 1. becoming more competitive with your labor force and 2. not able to buy your cheap products. Hmmm. You’re a communist country and are afraid of social unrest and you have a huge stockpile of UST/USD hanging out posing reward free risk.  I believe that China is trying to step in, but will ultimately be unsuccessful. CB manipulation can work for a while, but it is never bigger than the market.

Read about it here.

Of carry trades and unwinds

As the euro vol spikes, not to mention every currency pair imaginable, we continue to look to the currency markets as THE story of the day. I’ve often discussed the carry trade, the systematic leverage, and the deflationary impact of the debt reduction. The next level of analysis is to try to measure the size of the carry trade globally. As funds reduce their risk positions, funding currencies become stronger (witness the yen) against the risk assets funded. But if we could measure the extent of the unwind, we’ll be able to know when the yen should stop appreciating, since no speculator would be purchasing the yen for yield (virtually 0%).

While there are numerous ideas we’ve explored, I would like to share 3 articles (one general, 2 academic) that might interest our readers:

1. Fears rise for dollar carry trade future, by Peter Garnham at FT.com

At the World Economic Forum in Davos last month, Zhu Min, deputy governor of the People’s Bank of China, spoke openly about his biggest fear for global financial markets in 2010.“To me, the big risk this year is the dollar carry trade,” he said “It is a massive issue. Estimates are that the dollar carry trade is $1,500bn – which is much bigger than Japan’s carry trade was.”

2. Risk and return in carry trade, by Imad A. Moosa:

By using six currency combinations involving two funding
currencies and three target currencies, analysis of historical
data from the recent past and Monte Carlo simulations show
that carry trade can be profitable if conducted over a long
period of time, but the risk involved can be high. The riskreturn
trade off does not exist in the rational sense (a high
interest differential is not necessarily associated with a high
volatility of interest rates, and vice versa), since there is no
clear-cut relationship between the interest rate differential
and the movement of exchange rate. With a positive interest
rate differential the exchange rate is as likely to rise as
to fall, thus a positive differential (no matter how big) is no
guarantee of positive return. A significant adverse movement
in the exchange rate could wipe out the carry trader
on a single occasion.

The results show that carry trade may or may not outperform
stock market investment, but on average the former
seems to fare better than the latter. However, there are
caveats that must be taken into account when one attempts
to reach a conclusion of this sort. …
Other caveats pertain to two points raised by Burnside et al.
(2006). The first point is that although the Sharpe ratios associated
with carry trade may look high, the amount of money
that can be made out of this operation is relatively small. On
the basis of their results, they find that to generate an average
annual pay off of one million pounds, the speculator must bet
28.6 million pounds every month. In general, very large sums
of money are needed to generate profit of reasonable magnitude,
which limits the usefulness of carry trade for individual
investors, who are typically unable to raise this kind of money.
In the aftermath of the subprime crisis, not even most institutional
investors can raise this kind of money. What makes
things even worse is that the bid-offer spreads are increasing
functions of order size, which means that the rate of return on
carry trade declines as the transaction size increases. A factor
with a similar effect is price pressure, which drives a wedge
between average and marginal Sharpe ratios. This means that
as the transaction size increases, the marginal Sharpe ratio
declines towards zero, although the average Sharpe ratio
remains positive. Big transactions are needed to earn more
money from carry trade, but the rate of return declines as the
transaction size increases because of the bid-offer spreads
and price pressure.

Another problem with carry trade is that, unlike stock market
investment, high Sharpe ratios do not necessarily represent
compensation for risk because the payoff is not associated
with standard risk factors. If we consider the interest rate
differential as the source of return and the volatility of the
exchange rate as the source of risk, then (as we have seen)
the risk-return trade off in a traditional sense disappears.
Finally, we must not forget that returns on stock market
investments do not only come from capital appreciation (rising
stock prices) but also from dividends, which are ignored
in this exercise.

Carry trade has become very popular because of the perceived
profitability of the operation. However, it seems that
carry traders have been oblivious to the risk inherent in
such an operation while concentrating on the interest rate
differential. Excessive enthusiasm about carry trade has
been a reflection of herd behavior, similar to what happens
in any market bubble (although carry trade is not necessarily
associated with a bubble). However, it seems that taste is
changing away from carry trade, as reports surface about
large-scale unwinding of carry trade positions by institutional
and individual investors. If Dennis (2007) is correct in saying
that “carry trade falls out of favour,” then it is likely that a
lot of people have realized, in hindsight, that carry trade is
not as lucrative as it once appeared to be.

3. Evidence of carry trade, by Gabriele Galati, Alexandra Heath, and Patrick McGuire at BIS

Interest rate differentials have been a driving force behind exchange rate movements in
recent years. This has focused market attention on the role of currency carry trade
positions, and on the possibility that a sudden unwinding might adversely affect
financial stability. However, carry trades are notoriously difficult to track in the available
data. This special feature first outlines the investor base and trading strategies used in
carry trades, and then explores various sources of data to gauge activity.

(This article points to some data sources at BIS for measuring size of carry trade activity.)

Worldwide currency intervention

The same governments that ran up debts, kept interest rates artificially low, subsidized bad mortgages, etc., etc., etc. believe that they can adequately control the currency markets – the biggest in the world. So…

The Swiss National Bank is intervening, click here and here.

The Fed’s swap lines are all in effect and we’ll be finding ways to subsidize the Europeans.

Greece is testing the waters of exiting the euro.

Germany is out of its mind and announced that it’s banning certain shorting activity (only adding to jitters that it has no clue what it’s doing).

And here in the US we have continued whiffs of deflation, when all the Fed wants is inflation.

Look for continued competitive devaluations, currency controls, and other shenanigans.

The Silver Lining to the Debt Crisis

Here’s the by line from the article in Barron’s: “Could a Japanese debt crisis help spur a rally? Perhaps, if it fuels the yen carry trade.”

But rather than precipitating a panic, a decline in the overvalued yen would serve as a tonic in two ways.

The most obvious would be to give a lift to Japanese exporters, which have been hampered by the yen’s strength, not only against the dollar but even more so against other currencies. Remember, the greenback has appreciated markedly in the past four months against a basket of currencies, as represented by the U.S. Dollar Index.

Meanwhile, the yen has more than kept pace, which has two important implications. Relative to other major currencies such as the euro, the yen has gained even more. And relative to the Chinese renminbi, which effectively is pegged to the dollar, the yen has also risen, reducing Japan’s competitiveness versus that export colossus.

The effects of an lower yen were readily apparent Monday when the Nikkei stock average soared 2%, as the dollar firmed in reaction to Friday’s news of a smaller-than-expected dip in U.S. payrolls in February. But the positive momentum faded early Tuesday in Tokyo as the yen steadied.

The impact of a weaker yen would be felt worldwide if it spurs a renewal of so-called carry trade. That would involve using yen to fund purchases of other, higher-yielding securities. In its simplest form, a yen-carry trade might involve borrowing yen, costing practically nothing, to buy Australian bonds yielding 4%.

Then yen-carry pays the spread between the two interest rates. With the magic of leverage, that nearly four-point spread can be multiplied many times. Borrow, buy; repeat, to paraphrase the shampoo instructions.

The risk isn’t the usual one with leverage — a rise in borrowing costs. The Bank of Japan isn’t moving away from its zero-interest-rate policy any time soon; in fact, it is looking for additional means to ease monetary policy. The risk of the carry trade is exchange rates. But when the yen rises, the cost of that borrowing increases because the yen-carry trade is effectively a short sale of the currency.

That was readily apparent during the markets’ meltdown in late 2009 and 2010, when the dollar and the yen soared, partially because of a scramble for the safe haven of these currencies. But less apparent was the demand for dollars and yen to unwind carry trades — to cover those shorts. It was the mother of all margin calls.

Perhaps the best gauge of global markets’ risk appetite is the euro-yen exchange rate. When that appetite is robust, the euro tends to be strong and the yen is weak, and vice versa. So, as the Greek crisis built, the euro-yen rate went from about 133 yen to the euro in January to around 121 yen per euro, before backing off Monday to 123. When markets were in rally mode last summer, euro/yen traded as high as 138.

The ideal funding currency for a carry trade is one that is likely to get cheaper. One thing that ought to weigh on the yen is Japan’s parlous fiscal situation, which has gained increasing attention since Barron’s Jon Laing gave it the attention it deserved nearly six months ago (“Is the Sun Setting on Japan,” Sept. 28.)

For the full article, click here.

For readers of our letter, shorting the yen is not a new theme. In my opinion it is a fat pitch, with the main source of risk being timing rather than direction, so maintaining appropriate leverage is key. The secondary question is what people will do with the currencies that they purchase. For example, if you short the yen and buy dollars, where will those dollars flow? Treasuries? With mini-yields, they don’t really offer a good trade-off. Aussie bonds? Perhaps. I’m sure some fund managers miss the days of being able to buy some Icelandic offerings – but those funds are probably gone anyway.

The answer is that there could be a global carry trade, much bigger than the one described in the article, whereby dollars and yen and euro are used to fund risk trades. That trade is an inflation trade in another form – everyone wants to get rid of their cash and put it into assets (physical or financial). It’s not a long equity play at all, but rather a short currency play that is being manifested in the markets.  It would explain 17% U-6 unemployment, with awful demographics across Europe and Japan (especially), and a tapped out US consumer, with increased financial and physical assets.

There is another option…which is just that the markets are pricing in a recovery ahead of better numbers up ahead.

What we’re watching unfold…

Warning: This post has nothing new for readers of our newsletter. It’s just that things are unfolding almost according to plan, so we thought we’d put some of today’s headlines and moves in front of you, all in one place…

In no particular order:

• Italian derivatives draw scrutiny as Greece tensions heighten: Yes, Italy used currency swaps. It will turn out that others did as well. Are you surprised? 6 months ago, before anyone had coined the term PIIGS, we were discussing the crowded short USD trade, and the feeling that the markets were overconfident in Europe, even though it faced structural issues. The euro continues to face headwinds. Greece was the canary, but the real issue is Italy and Spain. We continue to be short the euro vs. USD.
• Coming Soon: Chapter 9 Municipal Bankruptcies: This was an interesting post about a little know quirk in bankruptcy law regarding municipalities. In essence, Chapter 9 gives municipalities protection from creditors as they work out payment plans. Guess who holds muni’s…yup, individual, taxable investors.
• PEW Study Shows Trillion Dollar State Pension Gap; Can Anything Be Done?: As if muni problems weren’t enough with tax revenues falling faster than expenses, Mike Shedlock highlights the looming pension shortfalls. If governments accounted for their liabilities like any corporation (other than Enron), they’d already be insolvent. We continue to hold no direct exposure to muni’s. When the stampeded out the door starts, every mutual fund and laddered portfolio will take a massive hit (and will form the basis of a once in a lifetime opportunity).
• Gold: I don’t want to write to much about this, but suffice it to say that Soros came out saying gold was in a major bubble (obviously hoping to talk the price down) as he accumulated one of the largest positions in the world. Read the full article on Soros here. Simultaneously, the IMF is selling some more gold (I won’t even link to it since it’s all over and is old news) and the market is waiting to see if India buys more (and front runs China again?). We’re maintaining our position in GLD, GDX, SLV, PALL, PPLT.
• Meanwhile, 10-yr yield is over 3.8%. We continue to have exposure to short Treasuries. Fun little graphic from Mike Shedlock here.

None of these are specific recommendations, since we do not know your particular situation. These are our thoughts and positions ONLY.

1937′ers: We were all looking in the wrong place for them

While Bernanke & Co. continue to fear pulling liquidity to early, we might be learning that the Fed is not as in control as we would like to believe. Today’s story about China increasing reserve requirements and nudging up interest rates provides an interesting canary for our coal mine. As readers are aware, I don’t believe any numbers coming out of China, but that being said, the reported growth is truly astounding:

Data released over the weekend showed mainland China’s exports rose 17.7% in December from the year-earlier month, trouncing the 4% rise expected by economists in a Reuters survey and marking a sharp rebound from the 1.2% fall in November.

At the same time, imports vaulted 55.9% during the month, also comfortably beating the 31% jump estimated by economists. The surge helped narrow China’s December trade surplus to $18.43 billion from $19.1 billion in November.

For full story, click here.

While we can argue about fake growth, or inefficient growth, or government stimulus making the bulk of this fake demand, the real issue becomes forward-looking. If China takes liquidity out of their own market, might it cause liquidity to be lower in the US? I believe it will. It might happen through higher rates, it might happen through decreased international trade, it might happen as our exports (already lagging where you’d expect given the dollar) continue to disappoint. The truth is that I’m not really sure of how this will play out, but I think the Chinese might be realizing they are in serious trouble and can’t sustain the absurd numbers they’ve conjured up, and like any ponzi scheme they will crumble under the pressure…eventually. I think they are trying to ward that off, but if I were a Chinese national with money in the bank, I’d be looking for ways to get it out, and this might have incredibly bad ripples for the US monetary authorities as our most valuable buyer of Treasuries faces serious problems that it was able to hide for the past decade.

If I were Bernanke, I’d be very worried about the Chinese monetary and banking games being played out right now – more so than any currency manipulation of the past.

http://www.marketwatch.com/story/analysts-divided-on-pboc-tightening-2010-01-12

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.

Notes from underground – Yra Harris