Portugal, and Yields, and Iran . . .

Portugal, and yields, and Iran - oh my! None of these are new stories. Portugal is bigger than Greece - but we knew that. Moreover, we knew Portugal was in dire straits. We knew Germany was already hesitant to provide more assistance and would demand higher guarantees.Viewing the remainder of this article requires a Subscription

The Hunt for Yield

I am not immune to the hunt. Yield can help you wait out a lot of volatility, and is especially important in times of questionable returns and incredibly low rates on savings. Pundits have been talking up the dividend yields of some brand name US firms such as JNJ or PG.Viewing the remainder of this article requires a Subscription

A Minsky Moment

From Wikipedia:

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.

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Lots of news, but what’s important?

There is a flood of data and headlines that seems almost spiteful to anyone trying to enjoy their usually-slow August. For me, it gives a good excuse to turn away and read even slower as most of the flood is meaningless for my portfolio. That being said, some of it is not.Viewing the remainder of this article requires a Subscription

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.Viewing the remainder of this article requires a Subscription

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

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

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.

All about the dollar

The euro and the yen are both weaker, sending the USD index higher – everything else is just being priced off the currency markets now:

Sure, gold:euro is going to break out to new heights. Yes, the asian currencies ex-Japan, will benefit against the yen and the euro. For me, the story is still in the G3 and hard assets, and then the resulting implications for the financial assets. I don’t see equities rallying in any sustainable fashion alongside the dollar. At least the curve is coming in a little, which eventually should help stimulate some lending, instead of just generating NIM.

Of course, it’s happening because 10-year yields are rising faster, which means that in the short term, borrowing costs will rise. Talk about unintended (but completely predictable) consequences: dollar is getting stronger, alongside higher interest rates – exactly the opposite of what Obama, Bernanke & Co. wanted.

Do we need to fear gold and USD going up together?

Spoiler alert: If you’re a serious inflationista, stop reading here. For those readers who are still open-minded and like to look at some other ideas…

For a while, we’ve been tossing around the different implications of inflation or deflation, stagflation or biflation. The ideas get complicated with ZIRP because at the limit, free money makes all relationships incoherent (think of the implications of negative TIPS yields, while experiencing deflation-like low rates in the 5 year treasuries; or the blowing out of the 10-30 spread – good for banks riding the curve, but for economy when banks prefer to lend to US goven’t rather than businesses).

The theme that I’ve been most inclined towards is some sort of biflation. To the same extent as “stagflation” was unthinkable until the 1970′s, biflation right now is unthinkable. Biflation will occur when we have deflationary pressures through a stronger dollar and lower asset (equities, bonds, real estate), coupled with increasing rates (contrary to any policy the Fed will implement). It means that cheap dollars won’t be recycled into risky assets and government securities. It is a new paradigm, and one which the Fed is not equipped to handle with its current set of tools.

Let’s start with the dollar. What would cause it to go up? The dollar will go up when investors realize two equally important things: the euro is flawed and eventually doomed and the yen is doomed.

How soon can the flight from the euro and yen begin? I think the turning point is upon us. Greece was a wakeup call that no one heeded and investors pressed the snooze button. Ireland is the next one. And if we fail to wake up, more calls will come. Already, German’s are starting to grumble about having to bailout their profligate brethren.

Taking one step back, the role of a currency is 4 fold:

• as a medium of exchange
• as a measure of value
• as a unit of account, and
• as a store of value

Each currency has some advantages and disadvantages in each category (for example, it’s really tough to use gold units in an accounting ledger, but it is bettter as a storage mechanism than a piece of paper that can be printed at will).

That digression brings us to why the USD and gold can go up together in this scenario. As flight from the euro and yen becomes a reality, US deflationary pressures will heighten with a stronger currency. At the same time, fear will drive assets towards gold. As one trader never fails to mention to me, “Gold will peak on fear, not greed”. He speaks truth. Perhaps its my own cognitive dissonance that allows me to think that gold and the USD can go up together, but the key is relative to what. I’m not making a call on which one will outperform on a relative basis (to each other). Rather, relative to all other assets or stores of value, both will benefit.

Which brings us to the ineffectiveness of the Fed. With a steep yield curve, banks have less and less motivation to lend to businesses – why should they if they can earn NIM by lending to the Fed? They shouldn’t. The translation mechanism from Fed to consumer is broken and QE is going to increasingly be seen as a pro-establishment, pro-Wall Street bonuses measure and the average US citizen will retaliate. First, let’s recognize that a steepening yield curve is not beneficial to anyone but the banks, and maybe that’s important as they try to fix their balance sheets, but maybe they should just take the charges and move on instead of putting taxpayers on the hook. Second, the money rushing around now looking for yield and return in risky assets is much like the money sloshing around in 1999 – misappropriated and bound for disappointment.

I have been discussing some of these themes for a long time, and have only been partially right (for example, metals have rallied since we spoke about them 2 years ago, but the yen is up significantly since last year when we went short). What makes me think now is any different? Even a broken clock is right twice a day. True. Yet, I will push back by saying that I was also early in advising clients to play it safe in 1998 and 1999 – 2 years early, in fact. However, the eventual collapse that clients avoided was not worth the potential upside. The same is here. The yen might go up from here, but the significant risk is to the downside. Same with equities. They might rally more, hit new temporary highs for a few days or weeks or months, but they will falter and it’s not worth the risk.

So, as we go into a weekend, after a huge run-up, QEII, elections, massive moves in currencies and gold at record highs, energy rallies (I like energy long term), unemployment numbers that are mixed at best, etc. I am wary and believe the fingers of instability are large and worrisome. We are indeed in a new normal, but it will not be a black swan when the corrections come.

Ever wondered what 1987 looked like?

I thought this was interesting. Here are a few charts that might give you a picture of what that famous year looked like. The danger, of course, is that it’s already in the distant memory for most investors.

The S&P 500 hit a new YTD high in August, then…

Gold meandered it’s way up:

The USD was on its way to making a new low byt the end of the year:

I’m not drawing any comparison, since I think we are in for a much more difficult period, more closely related to Japan’s experience than to the 1987 experience, but I always like to go back and revisit, especially when thinking through different scenarios and outcomes.

And I’ll end with a quote from John Murphy (Intermarket Analysis, 1991):

Consider the sequence of events going into the fall or 1987.  CRB prices had turned sharply higher, fueling fears of renewed inflation.  At the same time interest rates began to soar to double digits.  The USD which was attempting to end its 2yr bear market, suddenly went into a freefall of its own (fueling even more inflation fears).  Is it any wonder, then, that the stock market finally ran into trouble?  Given all of the bearish activity in the surrounding markets, its amazing the stock market held up as well as it did for so long.  There were plenty of reasons why stocks should have sold off in late 1987.  Most of those reasons, however, were visible in the action of the surrounding markets and not necessarily in the stock market itself.

China putting more reserves in gold?

Gold is rallying on rumors that China is planning on putting more reserves into gold.

The CRB in general is being pulled up by gold, while the counter-trader is to sell treasuries as investors worry that China won’t step up to the plate in the same way as it used to.