Separating the noise from the louder noise

There’s obviously been a lot of news since last night and I’ve been trying to wrap my head around it, but for starters let’s mention some of the big items:

Belgium and Spain are only the latest, but not the only(!), reasons for the euro to fall…and fall it did. We’re back to a 1.32 handle. Why do I say that they’re not the only reasons? Well, for starters, I thought the euro was structurally flawed before any downgrade, and continue to think so. The euro is now trading by default since there’s no alternative in Europe. Imagine for a moment if Germany came out tomorrow and said that it would start issuing Marks. The euro would be DOA.

On our side of the pond, we have treasury yields continuing to move up. 10 year yield is now above 3.5%! We’ve discussed the phenomenon before where we can have deflation AND rising yields at the same time. Locking in 3.5% for 10 years isn’t that attractive afterall. We’ve been calling it biflation, but I’ve been researching some underlying elements to help explain the phenomenon. Each time I come to the same issue: What cause yields to rise?

• If yields are REACTING to inflation and inflation expectations, then they are lagging commodities, but still part of the same message we’re getting from other asset classes. This could be bullish for equities and real estate, as well as supporting the runup of commodities in general (such as copper, industrial commodities, etc).
• If they are LEADING and are a result of fear over solvency, or frontrunning the pack (e.g. fear China will sell their holdings), then the recent run-up could be part of a debt-deflation cycle which is very negative and could be a harbinger of increased real costs of borrowing, economic slowdown, deflation across asset classes, etc. This would be very bearish for industrial commodities such as copper, but still supportive of precious metals as stores of value.

This dichotomy is the debate being had across the street. The first case is easier to deal with – we have the fiscal and monetary tools to stop inflation, and while painful down the road, we know it. The second case is similar to what happened during the Great Depression (and I don’t use that comparison lightly). It’s a world where fiscal and monetary policies are powerless, and it’s the scenario Bernanke fears most. Unfortunately, increased government spending does not and will not stop scenario two from occurring, so it just leaves us more vulnerable. We are maintaining our short treasury exposure.

Gold down. Oil up. Noise for me, since these are long term positions.

Muni bonds have gotten hit recently (as we predicted a few months ago). Noise for me at this point since we cut all exposure. At some point, yields will become attractive enough to take long term positions, but for me, not yet.

Tax bills, healthcare constitutionality, and WikiLeaks – all noise.

David Rosenberg (Rosie) discussing the rise of inputs versus no retail pricing power causing the mother of all margin squeezes?

The U.S. PPI, at +0.8% MoM in November and the core (which removes the effects of food and energy) at +0.3%, were both above expected but skewed by a seasonal rebound in auto pricing. Outside of that, core would have been as expected at +0.2%.

What is striking, however, is how cost trends are accelerating at the early stages of production in lagged response to the recent leg of the commodity boom. The “core crude” PPI jumped 3.1% MoM and is now up 30.2% on a year-over-year basis. This is the very early pipeline stage.

At the same time, core intermediate PPI leapt 0.7% and is up 4.7% from a year ago. When we get to final core goods PPI, the YoY trend is running at a mere 1.2% (and -0.7% on a three-month annualized basis).

In other words, the closer you are to the commodity complex, businesses have greater pricing power. And, the closer you are to the consumer at the final stages of production, the less pricing power you have. (emphasis mine)

That’s not noise. It’s just further confirmation that equity valuations are too high.

If you look at nothing else today

If you look at nothing else today, you must look at bonds.

Let’s go from shortest:

All the charts are weekly to give you a sense both of the magnitude of the current move and the potential for a continuation in the rise in yields. The short end has the most to catch up and we can see the historic steepness starting to come in:

Equities, in the meantime, are either blind to the turmoil in bondland or else have become the safe-haven trade. Really? Equities as the safe haven? BBY should at least give us a clue that valuations are priced for growth, increased leverage, etc. which probably will not happen. Any miss will be punished brutally at these levels. This is a set up. Even if we break through upside resistance, my estimation is that we are extended and overvalued, and that any rally is an opportunity to lighten up exposure.

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.

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.

What I’m watching

It’s Friday evening and the markets are closed.

“Bombs on UPS plane” barely registered, but I have to think that the terrorists have an awful sense of timing. Next weeks elections already look set to place more Republicans in power, and whether you agree with the different parties or not, as a terrorist, I have to assume you like the Democrats on the margin. Which begs the question – why would you put national security back at the top of the agenda? Same goes for North Korea, where there are reports of some shots being exchanged on in the DMZ. Why now?

In my little corner of the world, I’m reviewing. Let’s start with the yen. It’s at new highs…again! This is a 20 year chart of the yen index:

Why? There are things in this  world, Horatio…

I continue to maintain my short exposure, without much fear. I’m not levered, it’s a small position, and I’m confident that the long term prospects of the yen are even worse than the USD, even with the QEII that might be announced next week. The risk is still to the downside for the yen.

Back here in the US, I’m reviewing both the 10 year yield and the 10-30 spread.

Bill Gross came out and said two words about the end of the bull market and everybody suddenly listens. The Fed can announce QEII and commit to purchasing bonds ad nauseum; however, this market doesn’t need easing, it needs jobs and confidence, neither of which will be accomplished by Bernanke if they continue on their current path.

Take a look at the 10-30 yield spread. This is a monthly chart of the past 20 years:

It has spent most of its time in the 0.9 range, but hit all-time lows earlier this month of under 0.6. Now, where do you think the risk lies? For spread to continue getting weaker? No. The 30 is leading the way, but the 10 will follow.

Which brings me to Dr. Copper. I can’t tell you how many people bring up metals and commodities, with a view that there is no end to the upside potential. Maybe. Probably not.

Take a look at the S&P to the commodity equity index:

It doesn’t matter which representation you look at. Look at SPX to gold if you prefer:

What does it mean? It might mean that Dr. Copper is telling us that the recovery is full-steam ahead and that equities will start to outperform on the upside. I doubt that. The other option is that commodities are going to pull back and lead equities down with them, albeit not at the same rate. Considering that GLD is one of the most widely held securities in Merrills retail brokerage accounts, guess which way I think we’re going.

Meanwhile, financials are weak and facing continued weak real estate conditions, limited visibility on their portfolios, and weakening consumer lending conditions. Real estate and jobs continue to be the big macro hurdles. The elections are already done and the incumbents are screwed, even the ones that will stay in power will do so only through extremely difficult conditions – this is a non-story and already discounted.

What happens when everything happens?

The past couple of days have been a little odd, and they’ve left me less time to put pen to paper (keyboard to screen?) – what happens when the very things we anticipated start happening?

Let’s start with yields…For months we’ve been discussing the historic levels of the 10/30 spread:

It’s couldn’t get wider forever and as a value-guy at heart, I like finding these types of extensions and looking for reversions to the mean. We’re getting it, but there’s more to go.

What about on an absolute level? 10 year yields could go down to 2%, but the risk is definitely to the upside (for yields, downside for prices).

What about currencies? The USD index is finding some support, and I think it’s found a floor. There is a lot of speculative money that is short the USD (short USD/long equities was THE trade for the past few months).

Lastly, what about equities? Equities are overvalued on a fundamental basis. No matter what justification is used, bull markets do NOT start from these valuations. There could be rallies, and powerful ones at that, but we are looking at 10%-15% upside potential with 30-40% downside risk. That’s a bad trade and a recipe for permanent investment losses.

The arguments floating around that QE will push assets up are valid. I get them. The arguments that USD debasement will continue are valid. But they are flawed. The Fed believes these arguments and is basing their decisions on them. The idea is push asset prices higher to stimulate spending (the wealth effect) and get the economy going.

It will fail due to two gaping flaw: the market has already discounted the efforts and is valued based on those assumptions. In order to get prices higher, the Fed would need to surprise the market with ever increasing levels of QE. The second gaping hole is the assumption that prices will actually rise. Prices of real estate are poised for 20% more downside based on various valuation methods, or more in certain areas with excess inventory of up to 18 years worth of homes!! Prices of stocks are 30% overvalued based on the q-ratio, and at best fairly valued, so room for upside is limited. Prices of bonds are already extended and have no place to go but down. So you have the 3 main stores of wealth poised for declines. There is nothing the Fed can do to change that.

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?

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.

10-30 spread is blowing out

USD is weaker with the yield of 10 year vs. 30 year treasuries blowing out. This is a big red flag:

US is losing purchasing power and our ability to refinance our long-term debt is going to be diminished. The equity markets might be rising, but this is certainly NOT due to fundamentals – no bull market starts with a Shiller P/E of over 21! So the equity markets are becoming the vent alongside gold and silver and every other tangible asset. Vents for USD weakness are not being sought by money globally looking for a place to hide.

I thought Bernanke and Co. would fail in their attempt to completely ruin the USD, but maybe I’m wrong. Certainly, I’ve been wrong so far. They seem to be incredibly effective at debasing the dollar with no economic benefit. Where does it end? Not sure yet.

Yaron Sadan on The Wall Street Shuffle

Yesterday, I was interviewed on The Wall Street Shuffle where we focused on munis, treasuries, and yields – for the full interview, click here. One thing that came out towards the end was a brief comment on the Japanese yen – I usually like taking the other side of the trade of governments and CB’s, except for times when the governments are actively trying to devalue their own currencies. It turns out that CB’s are pretty effective at printing. It certainly doesn’t help when one of the main source of buyers for JGB’s, namely, the Japanese savers, are retiring and now need to draw on those assets. We remain short the yen – we were very very early (since the end of 2009), but the end game is nigh.

As for muni, treasuries, and rates – it’s the same story: we’re probably very early, but at some point, those prices will break and yields will go up.

What’s surprising today?

Markets are down, European liquidity is strained (check out LIBOR-OIS), oil is under $74 (under $73 as I update this), Spanish banks are sick, and more, all of which we’ve been discussing the past few months, and none of which is surprising. I thought that instead of talking about the same stuff we already know, I’ll point out some surprising moves today (in no particular order):

• Treasuries are going higher in a safe-haven bid (or maybe deflation sign), but gold isn’t. Gold has gotten the safe haven bid along with treasuries for a while, but today, that relationship isn’t holding. Who’s liquidating and why?
• The euro is acting much stronger than I would expect. Up 1.7%? What’s the unwind? Are investors covering euro shorts here or initiating new USD shorts? Not sure, but it’s surprising given the bad news out of Europe.
• Yen’s continued strength is surprising. The carry trade continues to get unwound and the yen is finding a bid. Will it break below 84? I’m short the yen for fundamental reasons (including bad demographics, insane debts, and lower exports due to world slow-down), but maybe the unwind can provide more support for a long time coming.
• Goldman staying strong is surprising. XLF is weak, but somehow GS is bucking the trend.
• AAPL upgraded by JP Morgan. Are they dumb? Or am I so behind in my understanding of tech that when I see all of Apple’s products as luxury retail I’m being the dumb one?
• I don’t want to jump on the bandwagon, but I am pretty surprised that BP can’t get a handle on this leak. I’ve heard reports that there are thousands (yes, thousands) of suck and salvage ships waiting to be deployed but being held up for political reasons. I’m not deep enough in the space to know if that’s true, but if it is, it’s an embarrassment for BP but even more so for our leaders (on all sides). The entire situation (except the accident) is surprising.
• Anyone buying Tesla shares is surprising.
• 3x levered bond ETF’s? Now? That’s surprising, but maybe I shouldn’t be.

I’ll stop there for now.

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.

Rising rates AND deflation? How?

I have been writing for months about a possible new scenario for economists: rising rates in the face of a deflationary environment. See, most people are either deflationists and believe that rates will go down, or inflationists and believe that rates will rise. What if they’re both half right (or half wrong)?

Foreign ownership of U.S. assets, particularly Treasury bonds, has increased significantly over the last two decades. Foreigners now own 57% of outstanding U.S. Treasurys, up from 37% in 1997. The chart above shows that this growth has been driven entirely by government purchases, notably China’s. In the two years ending in March 2005, official sector purchases accounted for 60% of new issuance, compared to about 40% historically back to 1960. The increasing significance of government participants, whose motivations are not always profit-driven, may help to explain Alan Greenspan’s famous “conundrum” — the question of why long-term interest rates declined in the face of strong economic conditions and rising short-term rates in late 2004 and early 2005. This disruption to the mechanism through which monetary policy normally affects the broader economy may one day work in reverse if governments choose to reduce their exposure to Treasurys back to 1960s levels. The resulting “reverse conundrum” — rising long-term interest rates in the face of weak economic conditions and falling short rates — would be far more unpleasant than the Greenspan version.

Source: Council on Foreign Relations