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Thursday, June 11, 2009

US Treasuries: Now What?

FN: Yesterday 10 year yields briefly printed 4.0% after the auction. Equities didn't like it and immediately sold. Things stabilized by the end of the day, with a yield below 4.0% and equities levitated off their lows.

But now what?

Treasury 10-Year Notes Yield 4% for First Time Since October: " Treasury 10-year note yields reached 4 percent for the first time since October on concern surging budget deficits and a falling dollar will prompt investors to reduce holdings of U.S. debt as issuance climbs to a record.

Treasuries tumbled 6.5 percent so far this year, the worst performance since Merrill Lynch & Co. began tracking returns in 1978, as so-called bond vigilantes drove up yields to punish President Barack Obama for quadrupling the budget shortfall to $1.85 trillion and raising the risk of inflation.

“People are increasingly concerned about supply,” said Jay Mueller, who manages about $3 billion of bonds at Wells Fargo Capital Management in Milwaukee. “The government running a deficit of 12 or 13 percent is not something we’ve seen since World War II. It’s very hard to digest.”"

FN: The deficits are set. Government debt supply won't decrease for years. Therefore the only part of the equation left to tamper with is demand. To prevent yields from spiking much higher and crushing an already crippled economy, a bid must be manufactured for treasuries.

Somehow liquidity must be coaxed out of risky assets, such as equities and commodities and funneled into treasuries to push yields down. The simplest way to do this is to inspire a "Safe Haven Bid". To achieve this outcome something somewhere has to be allowed to die... Lehman style. Perhaps the sacrifice of a few small Baltic states, such as Latvia, would do the trick.

Sure it sounds far fetched... but stranger things have happened. Somehow rising yields must be stopped. So how will "they" do it?

Latvia’s Woes Look Like Argentina All Over Again, Roubini Says: "Latvia's troubles resembles those Argentina faced early in the decade, said Nouriel Roubini, an economist at New York University.

Writing in the Financial Times, he said the Baltic nation faces a deep recession triggered by a global financial crisis, a sudden cessation of capital inflows and the need to cut an external deficit worsened by a greatly overvalued currency.

The Latvian authorities, backed by the International Monetary Fund, have set their faces against devaluing the lat, but foreign-exchange reserves are melting away at a frightening speed and the policy has to be reversed, Roubini said.

Without a depreciation of the lat, an adjustment of relative prices could occur only by means of deflation and a drop in nominal wages that would take too long and worsen the recession, he said.

The large foreign liabilities of Latvian households, banks and companies are in foreign currency, so a devaluation would lead to a sharp increase in the value of such debts expressed in lats and, possibly, to a surge in defaults; that would be damaging for Swedish banks that own the Latvian ones, he said.

Still, devaluation seems inevitable and the IMF's policy, which rules it out, is mistaken, Roubini argued."

India: Sustainable? Or False Hope?

FN: The India 30 Sensex (BSE) has rallied from a low of 7697 to 15168, or 97%. Bringing prices back to the pre-blow off top highs of 2007. In September of 2007 the index went parabolic even as the S&P 500 peaked around 1575. Hot money flowed out of North America and Europe an into emerging markets, pushing them to new highs on the ridiculous "Decoupling Theory".

Are things really good enough right now to warrant the very high prices of 2007? Global trade is still collapsing... just look at Japan and Germany.

Japan Economy Shrank 14.2% Last Quarter on Exports (Update2): "Japan’s economy shrank less than the government initially estimated as business investment and inventories fell at a slower pace.

Gross domestic product shrank at a record 14.2 percent annual pace in the three months ended March 31, less than the 15.2 percent reported last month, the Cabinet Office said today in Tokyo. The median forecast of 23 economists surveyed by Bloomberg News was for a 15 percent contraction."

FN: Despite a new, market friendly government the euphoria in Indian equities seems quite a bit overdone.

Wednesday, June 10, 2009

The Phantom Commodity Bull Market and the Consequences

FN: Everybody is talking about commodities and a "new commodity Bull market". The general consensus is that the "China growth story" is responsible for this. Well, yes and no. Chinese demand has indeed picked up, but not because of growth. They're hoarding.

Macro Man explains the Chinese "growth" miracle in The China Syndrome:

"Drilling down beneath the surface, however, we see a picture that is much less unequivocally bullish for commodities. While overall imports have barely started to recover in value terms, many commodity imports have absolutely skyrockjeted in volume terms. And at the end of the day, the inputs to China's industrial and investment complex are based on volume, not value.

Macro Man ran a study looking at the import volume of four different industrial commodities, comparing it with the trend of 2003 through mid-2008, a period in which Chinese growth averaged 11%. (Data for coal imports only begins in December 2004.) The results were remarkable."

(The charts over at Macro Man are mind boggling in their implications. You need to see them for the rest of this post to be in context.)

FN: There is something else to consider as well. PRICES. In a free market economy prices are a signal relied upon by both producers and consumers to adjust their behavior on the margin. This is how both supply and demand constantly adjust in a relentless search for equilibrium. When demand exceeds supply the price adjusts higher. The signal to producers id to increase production and to consumers to reduce consumption. Rising prices therefore NORMALLY signal an expanding economy... in other words GROWTH.

Currently, demand has continued to plummet or stagnate for commodities. However, prices have rallied, with oil hitting $71 a barrel. This price is actually incredibly high if taken in a broader historic context... and even more absurd during times of economic crisis.

The question is, if not demand, what then has driven a bid into commodities?

The economic crisis, while clearly global, has severely stressed the US financial system. It is now feasible that the US dollar will over time lose its reserve currency status. This makes the US dollar less attractive and by extension less valuable. Since commodities are priced in US dollars a weakening dollar is expressed as higher commodity prices.

This was already happening BEFORE the economic crisis hit and was part of the reason oil hit $147 the first time around. However the dollar decline was temporarily interrupted by a safe haven bid when the global economy collapsed. The combination of demand destruction and a suddenly strong dollar crushed commodities, sending oil down to $33.

Since then, demand hasn't recovered and despite massive production cuts oil inventories are at 19 year highs. But the US dollar has started weakening again and more importantly is expected to weaken further in the future. The natural hedge is to buy hard assets.

This of course is nothing new. What is new however, is that the US financial position is now very precarious. Loose fiscal and monetary policies have deployed and most probably completely squandered an absolutely disgusting percentage of the nations true wealth. This coupled with the already well documented demographic problem (health care costs) has made it starkly obvious that the US will indeed face great difficulties honoring these truly monstrous debt obligations in the future.

A very steep yield curve and rising rates on the long end of the curve are already signaling digestion problems. Important holders of US government debt, such as China, have already started to voice their concern. Financing this exponentially growing pile of debt has really become a concern. Rating agencies have even voiced their concern over the golden AAA credit rating of the US.

The only real solution for the US is an eventual de facto PARTIAL default. This would occur in the form of both overt (Fed buying treasuries) and covert (manipulating inflation statistics) fashion. Either way money will get printed and debt will get monetized. The US dollar will fall in value relative to hard assets such as commodities. To complicate matters, it can however, perform quite well versus other fiat currencies. A reduction of the debt burden to a level that is sustainable will suffice and can probably be achieved in an orderly manner.

While rising commodity prices may indeed be signaling the return of some economic stability, they are also signaling something far worse. They are signaling that concerned countries are taking unilateral action to protect the wealth of their citizens by hoarding hard assets.

Ironically higher commodity prices are a form of tax. Recall that when oil first rose above $100 equity markets would actually weaken on days oil moved higher. When prices hit high enough levels, they went from signaling economic strength to signaling an economic problem.

If anything in excess of $100 was a problem when the unemployment rate was 4.5% and credit was easily and cheaply accessible, what is $70 now? The unemployment rate is 9.4% and the financials system is crippled.

Combine that rising interest rates on everything from mortgages to credit cards and you've got yourself a real problem.

The real irony of it all is that higher commodity prices will destroy any "green shoots" that may have sprouted and its all because the desperate bailout of the financial system has so encumbered it that no other outcome is now possible.

Forget about a "V" shaped recovery. Forget a "W". This is going to be an "L" for quite some time.

Think lost decade.

Related Posts:
Green Shoots: Can't Water Them With Expensive Oil
Smashing the 'Perpetually Growing Oil Demand Myth'

Tuesday, June 9, 2009

Running out of Volume

The S&P 500 (SPX) is sitting on support around 930, but below the 200 day EMA (green line). Despite some days consolidating in this range, SPX is still overbought. Volume is also dropping off rather quickly.

Primary Market Total Volume (NYTV) is generally declining, even as the market rallies. The volume decline has now really started to accelerate. It would appear that the market is now rising on fumes... an example of which would be yesterday's late day jam job. These are done on low volume and are all about fixing a closing price.

Yesterday's candle is definite sign of indecision and is the fourth consecutive failure to close above the 200 day EMA. Until the Non-Farm Friday opening print high of 951 is cleared, it looks like this monstrous rally may finally be running out of steam.

Monday, June 8, 2009

Down and Out for the Long Term: This Time it Really is Different

FN: An excellent article by Wolfgang Manchu explains why there can't possibly be a quick recovery from this mess and why the world won't go back to business as usual.

Down and out for the long term in Germany: "Global current account surpluses and deficits add up to zero. So if everybody is saving more, who will be dissaving? It will have to be the corporate sector in the countries with large net exports. So if the US, the UK and Spain are heading for a more balanced current account in the future, so will the surplus countries.

The current account balance can also be expressed as the sum of the trade balance, net earnings on foreign assets, and unilateral financial transfers. In several countries, including the US and Germany, the gap between exports and imports serves as a good proxy for the current account. A fall in the trade deficit in the US, UK and Spain implies a fall in the combined trade surplus elsewhere. And as some of the shifts in the US and the UK are likely to be structural, this will have long-term effects on others. In particular, it means the export model on which Germany, China and Japan rely, could suffer a cardiac arrest."

FN: For a more graphical view of the carnage New N Economics has an excellent post: World Economic Reports. The graphs for Japan, South Korea, Malaysia, India, Indonesia and Thailand are pretty freaky. The export driven economic model is being torn apart.

Commercial Real Estate: Rising Rates Should Hurt

Real Estate (IYR) is coming up to serious resistance and the declining 200 day EMA (green line) on disappearing volume...

Furthermore, rising rates can't be good for commercial mortgages.

This is a good spot for longs to take their profits or shorts to start getting in.

US Dollar and T-Note

On Friday the 10 Year Treasury (TNX) broke OUT and UP of a Bull Flag. Rates are now moving pretty quickly. This is definitely not good for the real economy.

The USD (USD) strengthened impressively as well. The spin is that traders are expecting the Fed to start hiking rates as early as August. It is far more probable that traders are quietly getting defensive, selling equities and moving into dollars via the short end of the yield curve.