A Minsky Moment

A Minsky moment is when over-indebted investors are forced to sell good assets to pay back their loans, causing sharp declines in financial markets and jumps in demand for cash.^[1][2] In any credit cycle or business cycle it is the point investors begin having cash flow problems due to the spiraling debt incurred in financing speculative investments.

Lots of news, but what’s important?

Equity down, CRB up

Treasuries

Yes, it is insane.

Revisiting the 10 year

Revisiting the Curve

Remember when the curve was getting steeper each day? Remember when we started warning that the steepness was going to catch a lot of net interest margin (NIM) players flat footed when it finally turned? Well, it might be turning. Even if it goes back to the former steepness levels, I’m not sure it will surpass what we saw at the end of 2010. Here’s the 2-30 spread. Sure it can double dip, but the real issue is that 2 year bonds are being sold quicker than 10 year bonds. That’s not inflation – that’s stagflation, it’s deflation, or it’s bi-flation. Whatever it is, it’s not pretty for the long only managers.

Bill Gross loudly got out of treasuries, and just as loudly started shorting them earlier this month. Now, others are coming out of the woodwork on the trade (Jim Rogers, Michael Steinhardt, etc.). I’ve been there for a while, with a flawed implementation vehicle, but not bad given the magnitude of the move I anticipate and some challenges with shorting TLT. An even better way would be to structure the outcomes with options given the binary nature of the current environment. I’ve also been researching the newer ETN’s, FLAT and STPP, flattener and steepener respectively. Both are flawed and not my cup of tea, but I see the appeal and the use. Here’s a WSJ article about them. I think there are other ways to play the beneficiaries rather than ETNs on derivatives (a credit product which is a derivative to begin with, on derivative underlyings – definitely not for me at this point).

Relevant ETFs: FLAT, STPP, TLT, TBT

US Fiscal Challenge: A Minsky Moment?

I have to admit that the title is not mine, although oh I wish it were. Peter Hooper at Deutsche Bank just came out with a report (h.t. ZeroHedge.com) sporting this title. Not surprisingly, Hooper is trying to figure out the end game (aren’t we all) and concludes that if nothing else, the market is underpricing the possibility of a Minsky moment, namely a point in time where US debt faces a dramatic drop in prices as investors stampede out.

Our bottom line finding is that the relatively low risk the market attaches to US public debt belies a substantially higher degree of riskiness (indeed one about on a par with the euro periphery)indicated by standard measures of internal and external deficit and debt. While the debt ceiling hurdle will likely be jumped with only moderate disruption to the Treasury market, the challenges to a much needed fundamental reworking and redirecting of US fiscal policy are great. Failure of US political leadership to make substantial progress in this area in the next few years will substantially raise the risk of a bond market crisis.

Read the full report here.

The idea of a Minsky moment for treasuries is nothing new for our readers, but 2 things struck me. The first, is that there aren’t a lot of sell-side analysts discussing it. The second, is the focus on 2013, mainly because I anticipate that we might face a crisis sooner. Hooper’s analysis made another great point: if Obama is NOT re-elected, the US will face a situation with a  president that will want to be re-elected, which in turn implies a limited ability to address the entitlements and taxes that will need to be reduced and increased, respectively. In that light, Obama’s re-election is a necessary condition for change, as a second term president will have the capacity to implement more far-reaching changes. Very interesting.

In the early 1990’s, as a first term president, George Bush Sr., sacrificed his second term by increasing taxes and ensuring the US was on stronger economic footing. As the US faced the remnants of a war, the S&L crisis, etc. Bush’s move set us up for the following seemingly golden era of the Clinton/Rubin team. I don’t anticipate that Obama will sacrifice his second term in the same way, so Hooper is probably right that we might have to wait until 2013. On the other hand, as a discounting mechanism, the markets might start to foresee just that moment and move earlier.

Relevant ETFs: TLT, TBT

Is lowering the outlook legal?

Turns out that lowering the outlook from stable to negative IS still legal, and surpringly S&P actually did it. I thought it would never happen, but lo and behold, they did it. Here’s from their statement:

The negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years. The outlook reflects our view of the increased risk that the political negotiations over when and how to address both the medium- and long-term fiscal challenges will persist until at least after national elections in 2012.

Some compromise that achieves agreement on a comprehensive budgetary consolidation program–containing deficit reduction measures in amounts near those recently proposed, and combined with meaningful steps toward implementation by 2013–is our baseline assumption and could lead us to revise the outlook back to stable. Alternatively, the lack of such an agreement or a significant further fiscal deterioration for any reason could lead us to lower the rating.

Standard & Poor’s will hold a global teleconference call and Web cast today–April 18, 2011–at 11:30 a.m. New York time (4:30 p.m. London time). For dial-in and streaming audio details, please go to www.standardandpoors.com/cmlive.

It makes sense. Can’t fault them for stating the obvious, even if they are a bit late. Moody’s probably feels pretty foolish right now, and the administration is scrambling, but this is no surprise to many investors. Bill Gross is feeling like a genius right now.

I’ll write more on the topic, but the markets are moving pretty fast. Gold is bid. Everything else…well, not.

Yields

Slowly and quietly spreads of the 2-10 year treasuries decided not to blow out and instead have started coming back. What does it mean that in a world of increasing rates, we’re getting a flattening yield curve?

Here’s the 10 year yield:

Edging up slightly recently, and certainly not contracting. On the flip side, look at the 2-10 spread:

A few short months ago, hyper-inflationists were warning that this spread, which hit high after high, would blow out as inflation took hold, became rampant, and we’d be back to the middle ages. I was never in that camp, and while we see some inflationary pressures building, I think the main risk remains deflation as real estate, unemployment, etc. will drag down the consumer. Regardless, the 2-10 spread has come back from the brink and the curve is now flattening. I don’t know which way we go from here, but my analysis is still that rates are headed higher on an absolute level and the flattening yield curve supports my view that a recession or worse could be on the way. It’s a bad combination to have higher rates, deflation of stores of wealth, and a government with no ability to provide future fiscal and monetary stimulus.

Relevant ETFs: TLT, TBT, AGG, SAGG

Where to look?

There is so much noise that sometimes it’s difficult to focus. Today has seen some big moves across different asset classes, but I have to point out a couple:

• Silver making new highs. Without the fanfare of gold, silver continues to shine. I’m sticking to my original recommendation of splitting your precious metals exposure to silver, gold, platinum, and palladium. If it was happening by itself, I would say that it’s just a speculators game now. But it’s not. The precious metals are sending central banks a message. The metals were just a step ahead of bonds.
• Treasuries. Treasuries have rallied recently, but they’re struggling. Like a flurry in April, which signifies the death of winter, so too the recent rally is a fool’s bounce. Treasuries cannot be the refuge they once were; government policies have ensure that for the foreseeable future.
• Oil. Energy is a necessity, integrally tied to a country’s ability to produce good, but more importantly food. Instability in the largest energy producing region in the world will continue and provide a supply-shock-bid to the complex. I prefer the second derivative beneficiaries, namely, the domestic suppliers of coal and nuclear. Government policies will start bolstering these players as energy self-sufficiency will once again come to the front of the political debate.
• Emerging markets. Risk in EM countries has been underpriced for the past 10 years. Investors who piled into regions with no democratic and capitalistic foundations will have a tougher and tougher time getting out. Hopefully, investors aren’t holding large allocation to the region. Long term, I’m looking for opportunities to invest in India, not China; Brazil, not Russia.
• US equities. I have to throw in a mention. I am short IWM. Have been for a few weeks. Will stay for a while. Yes, I have long exposure in specific sectors and companies, but the overall market is unhealthy. I’ll have more to write about the specifics of equity valuation later in the week.

Relevant ETFs: GLD, GDX, PHYS, SLV, PSLV, IWM, RWM, TBT, TLT, INP, PALL, PPLD

10 year

What happened on Wednesday was the outlier, not the other days of the week. The entire curve has been getting weaker, except, obviously, the shortest of the short rates. Anything over a year, where the market is bigger, deeper, and more attuned to investing themes, is facing headwinds for now. Except Wednesday, right after the 10 year auction, treasuries rallied. Why? Truth is, I have no idea. On the run issues were bid and the spread to off the run issues wasn’t logical, so instead of one selling off, the other was bid. It didn’t last long, as Thursday, everything went back to where it started.

Sure you could buy these for a bounce, but as I’ve noted for a long time, the lows in rates are behind us.

10 year yields

The curve continues to frustrate the Fed. Taking the 10 year as a representative (although moves along the curve have not been equal as it’s gotten ever-steeper), we see yields continue higher and blow through QEII.

The market is already anticipating the political dilemma faced by the Fed: announce QEIII or not. It’s political because I definitely can’t call it economic. As the largest holder of treasury securities in the world, the Fed is facing massive losses as the  yields go higher, AND on top of it, they don’t get the benefit they wanted from lower rates. It’s the worst of all worlds for them. I’ve been hearing about people trying to play the bounce in treasuries, and it will come, but the fundamentals are finally becoming reality – rates are too low and all metrics based on the risk-free rate need to be re-priced.

Treasuries – Can we finally agree the bond bull is over?

Treasuries continue to fall. 10 year yield is sitting at 3.6% and it doesn’t look like they’re heading back to 2.6% in the near future. Maybe we’ll have a bounce, but the bond bull is over – it has been for a while.

In an environment with increasing yield, can equities continue to rally? The answer is easy: it depends.

If yields are rising due to inflationary pressures, than equities can rise as corporations gain pricing power, are able to pass on rising costs to the end consumer, and earnings rise in line. However, if yields rise due to a debt deflation cycle, where companies have limited pricing power, but debt gets revalued lower, then equities will be hurt. My fear for a while has been that we are entering the latter. Yesterday, I increased our short exposure to equities, and maintain a large cash position. I have been early for a long while on the end of the equity surge, but have not taken the other side actively until this week. I think we’ll start with an 8-10% correction, which investors will think is an opportunity to buy-the-dip, but any bounce will be short-lived.

In the meantime, fears of inflation coming from commodity speculators will prove ephemeral, as debt deflation leaves companies with less pricing power, and will just serve to squeeze margins. I still like the precious metals and energy, but I’m not putting funds to work in the ag space at these levels.

Relevant ETFs: TLT, TBT, SH, SDS, SPY, IWM, RWM, TIPS

The Great Vega Short

Artemis Capital just put out this interesting report (HT: ZeroHedge) about the Fed conducting the largest ever short of vol in history:

The Great Vega Short

In theory the Federal Reserve is now the largest volatility trader in the world because current monetary policy is akin to shorting massive amounts of volatility and assuming tail risk. The current regime of monetary and fiscal stimulus is similar to writing a naked put on the entire financial system with margin backed by the US debt. The premium received from the sale of the naked put is financed via demand for our debt and redistributed to the investor class to re-flate underlying asset prices and depress volatility. The theory is that the reinvestment of this premium by investors into underling risk assets ensures the Fed’s naked put is never exercised. In effect, the Federal Reserve is constantly shorting vega on a systematic level. This stimulus regime socializes “tail risk” to generate short-term prosperity. If asset prices drop the Fed is forced to sell more volatility to artificially support prices. This will work as long as (1) asset prices do not collapse too far or; (2) taxpayer funded margin is unlimited. If either of these two conditions are not met the asymmetrical return distribution of the strategy will result in complete ruin. It is a martingale process, similar to constantly doubling down your bet while gambling (with better odds though). It works only if your bankroll is unlimited.

Read the full report here.

This doesn’t end well, but the timing is difficult.

A new year, but not much has changed…

Sure, it will take a couple of weeks to get used to the “idea” of 2011, if not the reality. The main changes with any new year, in terms of investments, are structural. Tax losses have been taken, performance numbers have been set, bonuses have been calculated, etc. It is also a time of prediction, which is always a fun game.

For me, though, it’s also a time for reflecting. I spent most of 2010 getting increasingly concerned about valuation and inter-market relationships, most important of those is the impact that currency relationships will impact other asset classes. As I turned the annual leaf, I thought I would reexamine that posture, from both a numbers perspective, but also a bigger, more conceptual perspective.

It ain’t pretty. From a valuation perspective, the equity markets are as overvalued now as they were at multiple other peak, except 2000:

• The relationship of the S&P 500 to a regression trendline (more)
• The cyclical P/E ratio using the trailing 10-year earnings as the divisor (more)
• The Q Ratio – the total price of the market divided by its replacement cost (more)

“To facilitate comparisons, I’ve adjusted the Q Ratio and P/E10 to their arithmetic mean, which I represent as zero. Thus the percentages on the vertical axis show the over/undervaluation as a percent above mean value, which I’m using as a surrogate for fair value,” said Doug.

According to this methodology, the Index is overvalued by 63%, 43% or 38%, depending on which of the three metrics you choose.

Source: dshort.com

These fundamental indicators are really bad timing mechanisms, because each of them could continue extending, but they all point to the same thing: equities are in a danger-zone.

What about treasuries? When Bill Gross, who in 2008 supported a trillion dollar deficit, now writes:

• American politicians and citizens alike have no clear vision of the costs of a seemingly perpetual trillion-dollar annual deficit.
• Policy stimulus is focused on maintaining current consumption as opposed to making the United States more competitive in the global marketplace.
• Dollar depreciation will sap the purchasing power of U.S. consumers, as well as the global valuation of dollar denominated assets.

Read the full article here.