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.

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.

Random thought on corporate debt

Companies are issuing debt left and right, and I don’t blame them at these rates. 100 year bond offerings? Sounds kind of crazy to me that investors would take it. Which made me think about those days oh-so-long ago in 1999. One of the hallmarks for the equity bubble was that companies were issuing stocks at ridiculous valuations at record pace and investors were buying.

Here, now, we have the same, but different phenomenon: companies are issuing debt at ridiculously low valuations and investors are buying. Hmmm.

Just a thought. Anyway, this article came out in the NY Times this morning.

Starting the day off

Markets are down about 2% as I write this. Yesterday the market started realizing that in case of emergency, the Fed has only QEII at its disposal, but simultaneously realized that it can’t buy anything else. What to do? In a debt deflation cycle, all assets that were propped up by debt need to be deflated. Real estate is well on it way, but isn’t done, equities, and soon, debt itself.

The biggest surprise is the yen. It just keeps getting stronger. Is this unwinding across the world? Still? I don’t know, but the yen strength is one of the many disconnects in the market that make me anxious about the end game.

To be continued…

From the Fed: Future Recession Risks

Future Recession Risks

by Travis J. Berge and Oscar Jorda

An unstable economic environment has rekindled talk of a double-dip recession. The Conference Board’s Leading Economic Index provides data for predicting the probability of a recession but is limited by the weight assigned to its indicators and the varying efficacy of those indicators over different time horizons. Statistical experiments with LEI data can mitigate these limitations and suggest that a recessionary relapse is a significant possibility sometime in the next two years.

For the full paper, click here.

There’s nothing more to say. The Fed is starting to recognize that risks remain to the downside. It supports the view that rates will be kept low for the foreseeable future.

Morning notes

A lot of huffing and puffing around town, but you should have already been positioned:

• Euro is taking out 1.22, on it’s way to 1.20 and lower. 3M Libor is going up, as we discussed a few weeks ago. European lending/borrowing costs will rise, banks will be hurt, and sovereign debt will need to be repriced. Spanish banks are especially vulnerable given the liquidity crunch coming up once European facilities need to be rolled over in July.
• China can’t hide the numbers any longer. Why would they lie? Because THEY”RE COMMUNISTS! Government numbers in general are massaged, but in communist regimes, it’s on a different scale. For those who remember 5 year plans, pictures of stocked Russian supermarkets, talk of the US falling behind on every level, this is just more of the same – in the end, communism and state directed economies fail. Not a value play (yet?) for me.
• USD is getting stronger and weaker: stronger vs. euro (duh) and weaker vs. yen (huh?). Continued unwinding of the carry trade? Domestic yen coming home from international allocations?
• 10 year yields are saying deflation, and they’re saying that the US government has some leeway since investors still think it’s credible. So good so far.
• Are we on the brink of massive quantitative easing on a never-before-attempted scale? Competitive devaluations? Against what – each other? USD? Gold?
• Real estate: how come when I say real estate is vulnerable you don’t listen but when Meredith Whitney says it 6 months too late, everyone is up in arms. And now Barry Ritholtz and John Mauldin are confirming? Nice, but I hope my readers were already out of the space for the time being.

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.

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

The equity markets were down today…

…is one of the bigger understatements I heard in the news. Not only did the DOW drop 376 point, the S&P fall through key technical levels, and the Nasdaq fall off a small cliff, everything else was down too – except the euro and the yen? What is going on here?

It will take years for the current cover-ups to be revealed, and I am not much of a conspiracy theorist, but the move by the Swiss yesterday and today was out in the open, while the moves by some unknown buyer (rumor has it that it might be Uncle Sam) was top-secret. Well, as governments start to believe that they can control currency levels, rates, money flows, etc. inefficiencies will only increase. Check out this article about China’s recent resource hoarding.

The international trading system is about to encounter an entirely new challenge. The global hunger for natural resources is inspiring a surge in restrictions on exports of crucial raw materials. As with so much else in trade nowadays, the focus of this emerging conflict is on China. The Chinese stand accused by some trading partners of hoarding rare elements and other raw materials that are essential to many globally traded products.

But China is hardly the only country considering export restrictions as the race for natural resources heats up in the wake of the recession. The sharp increase in restraints is happening world-wide, and raises fundamental questions about the rules and the resiliency of the World Trade Organization…

But you can’t fool all of the people all of the time. I am not a technician by nature, so I have to go back to valuations. I’ve said it before: equity markets continue to be 30% or more overvalued. Real estate across the board is overvalued. There were a round of recent speculators that were probably able to make some money, but commercial real estate is going to continue to be a drag on regional banks, and ripple through the economy.

What is surprising is the continued inhuman strength of the yen. I’ll be looking for opportunities to increase short exposure to it. While I expect yields on 10-year to be bid as a safe haven, they are in a precarious position and I don’t think they’ll go below the 2.5% range, so I’ll be looking to increase short exposure there as well. In the meantime, we wait. The opportunities to buy will be there in the future, but for now, capital preservation is the order of the day.

As a sidebet: how long before we hear about a large hedge fund liquidation?

Ratios, gold, and reflation

For most people, thinking in terms of absolute returns is natural, thinking terms of relative returns to a benchmark has become acceptable, and thinking in terms of relative returns between asset classes is far off. At it’s simplest, by making an investment from cash holdings investors are making a relative consideration: the investment should outperform cash over the anticipated holding period. Sounds pretty straight forward.

In the past 5 to 10 years, charts showing the Dow vs. gold have been floating around. While it sounds simple, this basic premise is actually at the heart of investing and a focus for macro traders. Currency investors are used to thinking of investments as relative between pairs of currencies, or in complex strategies, relationships between multiple moving yet interrelated parts.

Why all the intro?

Recently, I’ve been speaking to a number of traders and investors about the inflation/deflation debate and it’s implications for investors in the future. One trader (H.T. Macro Man) in particular prompted me with a seemingly simple thought: it’s not whether you’re long or short – it’s WHAT you’re long and short, as massive rotations, rolling bubbles, and inflation/deflation get implemented across and within asset classes.

So today, I want to highlight a couple of the ratios we’ve started exploring with some of the implications:

Everyone knows that gold has been going up.

As it has, if we start looking at other assets priced in gold (I’ll use GLD as a proxy for our conversation) we start seeing some potentially undervalued opportunities.

(Source: The Big Picture)

It doesn’t mean the S&P is cheap, nor gold expensive, but the S&P priced in gold is certainly not as expensive as it was just a few short weeks ago.

But to continue our exploration…

Check out the agricultural sector (DBA used as proxy) priced in gold:

In 2005, Marc Faber discussed asset inflation vs consumer price inflation in his Gloom, Boom, and Doom Report and included a discussion of gold as an inflation hedge. The conclusion was that gold was a better hedge for deflation, perhaps as we’ve seen in the recent action, while agriculture was a better inflation hedge. Could the extension of this ratio signify the end of deflation and the beginning of inflationary pressure?

What about moving away from commodities and looking at some other relationship? As readers know, I’m not a big fan of the euro. Traditionally, bad political structures lead to significant underperformance over the long term. In that light, we have distrusted China, Russia, and the euro (the currency not all European firms). Last week we looked at putting money to work in Greece (while short the euro), which has turned out OK so far, with both NBG and OTE holding up nicely from our entry point. But what about the larger picture of the eurozone countries? I’m still pretty negative long term on the euro, but look at the relationship between EZU vs. SPY:

There is a good chance the relationship will get more extended before reverting, but it’s worth noting that at some point the eurozone countries will become a significantly undervalued relative to the S&P.

Lastly, Gartman brought up this relationship recently and it’s one a lot of traders I know have been looking at: euro/yen. While I’ve been focusing on the euro/usd, and anticipate that it will continue to weaken, euro/yen has broken down after having been in a relatively tight range:

What does it tell us? Money is coming out of the euro and going into yen. Risk is being taken off the table as carry trades are unwound and money is going back into funding currencies. This has obviously been a problem for both the US and Japan which are themselves trying to stimulate inflation. Japan has already announced additional quantitative easing, and the US is sure to follow…which leads us back to where we started…

Money will need to find a home in an environment of competitive devaluation, and while deflationary pressures have “won”, I believe that we are close to a turning point. I anticipate that it will translate into a challenging environment for bonds (increasing rates) and a potential opportunity for agricultural related investments (certainly relative to other asset classes, if not on a local currency basis). I’ll continue exploring implementation methods in the upcoming weeks, but I’ll certainly be looking at the ratios to find the undervalued assets.

Around the markets in 6 charts or less

Markets have been moving so fast and long standing relationships and correlations are being called into questions, but we’ll try to highlight a few of the areas we think are worth watching

CHART 1 SPX

Today intraday, the S&P broke 1185 support and fell directly to the top of our target area. The euro is driving the global markets on an absolute level, but the S&P continues to OP most global mkts. It’s now testing 50dma, while volume and $$ traded are inline from yesterday. The good news (so far) is that we held ABOVE panic opening lows. Rotations were clearly evident from the opening print – XLU XLV XLP were all positive out of the opening gate.

CHART 2 IWM

Meanwhile, the Russell 2000 intraday broke 72 support level and touched first target at 70.  This “SHOULD” act as a support area. If we bounce towards the 72-73 range, it will provide a great shorting opportunity. We believe that if global markets bounce (and that’s a big IF), EU may be the receiver of investable funds and the EZU/IWM spread should close up.

CHART 3 TNX

The 10-year yield closed below the 3.6% support level. We believe that the UST is no longer a safe haven on an absolute basis. In a world of competitive devaluations, we expect the US government to issue debt at unprecedented levels, yet, interestingly enough, they announced that they’ll be cutting issuance. We believe this will be temporary. Should the euro bounce on new bailout talk, we expect UST will weaken.  For the time being, safe haven bid remains.

CHART 4 DXY

The US dollar index is up 3.7% QTD and 8% YTD. Simultaneously,  secondary FX starting to get thrown out as EU problems spread. Safe haven bid in USD remains – Target seems to be 85-87 area – its anyones guess. Should we get to those levels I would recommend buying AUD, CAD, and the other resource based FX, but only after the euro has a bounce toward 1.32-1.35 area.

CHART 5 Gold: S&P

Bounced off the lows and continues to move north: Gold is THE safe haven in a global. Resistance in spread 1.5% away. GLD above 116 – 120 would signal new highs with a 135 tgt.

CHART 6 SPX vs IWM

YTD, we see IWM strengthening vs SPX (big) – rotations within SPX are starting to favor lagging sectors. Still, we have time before the all clear signal. We believe any rally in the EUR which causes Europe to rally will most likely come at the expense of IWM.

This market has absolute moves that are making headlines, but it is the RELATIVE moves that are the keys to understanding the markets. Rotations between regions, rotations between laggards/leaders, and rotations between large and small continue to drive turbulent moves. The Keynesians running the show didn’t account for sovereign defaults, but the CDS markets continue to offer clues. Tomorrow, Spain and Britain may be in the crosshairs. Again, the questions are no longer whether one is short or long, but what one is short or long.

More on inverted swap spreads

The inversion of the 10 yr swap spread (10 year swap spread = 10 year LIBOR yield – 10 yr UST yield) might be the biggest under-reported story since…well, so many big stories out there…

ZeroHedge ran a summary of a report by Morgan Stanley and they did such a great job, that I won’t try to do better, but rather, encourage everyone to read this article.

One line from MS:

The issuance of UST debt is dwarfing Libor-related issuance. For example, we expect UST net issuance to be $1.7Tr and net issuance of MBS to be zero. Thus, the relative issuance of UST’s vs. Libor-based products mainly accounts for the inversion in swap spreads. This is a first sign of stress leading to higher UST yields and is not to be missed. (Their emphasis.)

Bill Gross out with a new commentary

His conclusion – .01% yield on cash is pathetic, all other options are scary, so play it in between and buy utilities at 5-6% yield with limited upside growth. For the full reading, click here.

The coming rerating of debt

What happens when local state governments face a shortfall in budgets, have to issue new debt, and face a market with no natural buyers? You guessed it: Yields on muni bonds will go higher, while yields on Treasuries, which are being bought by the Fed or banks, will stay low. What does this mean? Yup, a tax arbitrage opportunity on a massive scale. What you’ll soon see is that the Federal government, will have to close the deductibility of muni interest, and in essence impose a new tax on individual investors. It won’t take long to see the implications. New York is facing a cash crunch in December, and it’s not alone: http://www.bloomberg.com/apps/news?pid=20601087&sid=aEWj6.QiznOU.