Behavioral Macro

Trading Fixed Income: Falling Knives, and EM local (market views)

Sun, 02 Jun 2013 20:25:00 -0400

Do you think the selling in the Treasury complex is over—at least until next Friday’s NFP? It you are a trader, this is really the only question you have to ask yourself right now.

There has been massive pain in the fixed income world over the past three weeks. The backup in Treasury yields finally attained the speed necessary to shake carry traders across the FI spectrum into shedding risk. It got particularly ugly in EM local fixed income and currencies (more on that later). The risk-shedding eventually spilled over into the equity markets.

Odds are good now that we are at that kind of win-win juncture for FI risk that you don’t that often see. Kind of a David Tepper moment for FI traders. I think the selling in the T-plex has been strong enough for long enough that it would take big fundamental news to drive them further down from here. And I can’t see anything important enough in front of the NFP to fit that bill.

This leaves us with two basic scenarios. One, if the equity market rebounds, the ‘fear discount’ now built into a lot of FI instruments will come out and Treasuries should stabilize if not rally, given the speed, fear and volume behind the recent selling.

Two, if, instead, the equity market sells off further from this point—which we got a taste of on Friday—then Treasuries will rally, as they tend to when risk aversion rises far enough or fast enough in equities. In fact, we got a taste of this on Friday as well. This scenario should trigger at a minimum a modest rally in the some of the FI instruments hit hardest by the bond selloff.

Both scenarios have implications for the dollar and tend to be bearish, but more on that below.

Of course, if your scenario doesn’t envision Treasuries stabilizing, then you stay just out of the way.

If, however it does, you then have to consider the follow-up, investor question as well: Has the market too aggressively discounted the timing of the Fed’s exit process? This is not the same as the first question. If you believe the answer to this question is also yes, then this is probably a good entry point to buy beaten up FI instruments for a longer timeframe, not just for a trade (FWIW, less than 3 months is the trading bucket, more than 3 the investment bucket).

Three FI sectors warrant separate discussion here, IMO: Agency mortgage REITs, currencies and EM local currency bonds.

Agency Mortgage REITs

- Selloff started last September

- The sector is now retail-dominated and emotional

- I put the current discount to NAV at ~10%—but this is a guesstimate, conditioned in no small part by the magnitude of the decline in book value last quarter

- The sector is in cyclical downswing, but discount to NAV and carry offer good protection right now against being wrong, even when dividends are cut.

Ccy, PMs and EM local FI

Correlations have been low, making things tricky. Positioning is heavy and will be the driving force in the near term, IMO, especially if the equity market tumbles further. If you believe USTs will stabilize, you are likely to see a decent rally in funding and hedging currencies (EUR, GBP, AUD, NZD, CAD), and in JPY where positioning is so heavy even higher UST yields were unable to lift USDJPY. You’ll also likely see a squeeze in precious metals, where a lot of shorter-term traders and CTAs are positioned short. Even though I dislike precious metals in the longer term, I think odds right now favor an especially good trading opportunity in the gold miners. There’s a fair number of people long dollars against the majors and precious metals at this point. Caveat: short dollars anywhere except JPY gets a lot trickier if USTs stabilize and SPX sells off hard.

It is less clear how much EM currencies rally if the big dollar sells off, if at all. This is an area where there still is short-dollar positioning, and, frankly, it is humongous. USDMXN has moved 80 big figures and long-term holders were only just roused from their slumber last Wednesday. My guess is any rally in EM currencies will be used by institutional investors to lighten up, driven by this wake up call and their longer term cyclical views.

The big trade for many macro types has been long EM currencies and short a basket of developed currencies. This allows macro guys to be long EM ccys while diversifying away much of the EURUSD risk by using a funding basket. Shorting AUD hedges SPX and Asia slowdown risk as well. This trade is as old as dirt. Problem is there are many more guys holding dirt these days. And RM, both dedicated and crossover, have piled into EM local ccy bonds (look at the ticker $EDD). Few outside the asset class know how large it has grown relative to the target market. And those in the asset class have kept mum to increase AUM.

These local bonds are too difficult to sell in size, so if redemptions get large enough where RM funds have to reduce bond holdings, it will get ugly. In the meantime, the big investors will buy dollars against their EM local bond holdings to protect those positions as best they can. Few investors in EM local ccys bonds realize the extent to which overall returns in the space are driven by currency and not the bonds themselves.

I know EM fundamentals are better in most EM countries these days, but that is not much of a defense once we tip over into the liquidation mindset—and odds are good that we have. The participation in the asset class is just much, much broader than it has ever been. Plus, the sell-side market-making is a lot thinner. So, even if you think USTs stabilize, this is not the asset class to play. Many large players will be looking for the exit on any decent bid.

Market update for a friend

Mon, 13 May 2013 14:01:00 -0400

I spend more time than I probably should exchanging views with other market participants, most of whom are friends. It can take up a lot of time. My exchanges with one guy in particular, a macro guy with a strong background in economics, usually capture best where I’m at. I’ve posted my side of these exchanges a few times in the past. The similarity in backgrounds usually leads to a very efficient exchange of ideas—even when we don’t agree. We just speak the same language.

I had the impulse this weekend to write up my views because I changed my positioning last week. But, busy with other stuff, I never got around to it. Lucky, my macro/economist friend wrote me an email today soliciting my views. This forced me to hammer them out. Here they are, excising, of course, the personal pleasantries in the first para, and the salutation in the last:

“As for the markets, I just took down much of my long equity exposure, the day USDJPY broke 100. I think the dollar has more to rally and, even though the correlation to equities has been low, if for whatever reason the dollar rally accelerates, stocks could take a breather. I have had a good run so I don’t mind taking equity risk down and re-assessing. I am keeping positions in less than a handful of key equity names and will continue to watch. Still have long AAPL, short precious metals, for example.

My only high conviction positions right now are: being long dollars (biggest position is USDMXN, which I think is technically most vulnerable) and short silver, gold and a little bit of oil. My view on there being a bubble in commodities that is unwinding has not changed, despite the mini-crash in precious metals last month. On a scale of 1-10, risk is now a 5 for the book. I had been running closer to 9 for a while.

I am still bullish on the fundamentals in the US. Europe’s day of reckoning will come, but in my base case it is a fair ways down the road. EM will grow less than expected, but expectations are not too high. I don’t expect any blowup in EM. Further upside in USDJPY is mostly idiosyncratic here, and fairly heavily positioned, but USDJPY coming off hard would be one of the clearest indications of risk off/position liquidation I can think of.

I feel there is too much fear of a Fed exit (there is risk, of course, but IMO we are overpricing it, both in timing and magnitude of impact). And the wedge between valuations and fundamentals is less than what ppl argue, not least because the macro continues to heal under the surface (HH debt better, jobs slowly better, budget improving fast and not “priced in”).

US growth will still be anemic—structural/latent globalization issues will keep a lid on US wage growth, but too many ppl are too deeply pessimistic and are hanging their hats on the Fed blowing things up—because all their theses so far have been wrong. It’s like at the end of the football game and the team is betting everything on the long pass (the Hail Mary play) because they are so far behind in the score.

The above language may seem a bit cryptic and not fully fleshed out, but I hope it’s better than not putting the views out at all.

There is zero correlation between the Fed printing and the money supply. Deal with it.

Sun, 12 May 2013 15:54:00 -0400

There is zero correlation between the Fed printing and the money supply. If you don’t believe this, you owe it to yourself to study up on monetary policy until you do.

This is an issue that brings them out of the bunker like no other in economics. But if you are an investor, trader or economist, understanding—and I mean really understanding, not just recycling things you overheard on a trading desk or recall from econ 101—the mechanics of monetary policy should be at the top of your checklist. With the US, Japan, the UK and maybe soon Europe all with their pedals to the monetary metal, more hinges on understanding this now than ever before.

And, as we saw this week, even many of the Titans of finance and economics have it wrong.

“Wrong? You’re saying they’re wrong? They have tons of money. They have long track records. I mean, they’ve seen it all. How can you say that? That’s just arrogant. Besides, did I mention they have tons of money?”

Here’s why the Titans are wrong

Brad DeLong had an entertaining piece on whales, super whales and men who hate the Fed, but the answer is much simpler than the one he offers. In fact, if you’ve ever been in the belly of a hedge fund, you know the answer to most everything is much simpler than it appears to the mere mortals on the outside.

The bottom line is the titans are working from the wrong playbook. We’re all, to varying degrees, slaves to our experiences. Their formative experiences, almost to a man, were in the early 80s. This is when they built their knowledge and assembled their financial playbooks. They learned words like Milton Freidman, money multiplier, Paul Volcker, Ronald Reagan, and the superneutrality of money. Above all, they internalized one dictum: real men have hard money.

This understanding implies that an increase in bank reserves deposited at the Fed (i.e. “printing”) eventually feeds credit growth and thereby inflationary pressures; in other words, no base money increase, no credit growth. Only one problem: reality disagrees.

Here are the facts

From 1981 to 2006 total credit assets held by US financial institutions grew by $32.3 trillion (744%). How much do you think bank reserves at the Federal Reserve grew by over that same period? They fell by $6.5 billion.

How is that possible? I thought in a fractional reserve system base money had to grow for credit to expand?

The answer is structural. The financial deregulation that began in the early 80s (significantly, the abolition of regulation Q) and the consequent development of repo markets fundamentally changed the transmission mechanism of monetary policy. Collateral lending is now king. Today, length of collateral chains and haircut rates—neither of which are determined by the Fed—define the upper bounds of the money supply, not base money and reserve requirements.

What about the relationship to inflation? Isn’t base money correlated to that? Here’s a graph, from this piece by central banking expert Peter Stella.

The X axis shows 5-yr growth rate of base money (loosely defined) and the Y axis shows annual yoy inflation. That’s right. Nobody home here, either.

Don’t confuse liquidity with credit

The Federal Reserve only provides liquidity. The amount of liquidity it puts in the reserve system has no direct impact on the issuance of credit by banks or shadow banks. Only banks and shadow banks can create credit. And they lend either out of cash on hand or by repo-ing treasuries, mortgages, or deposits, if cash on hand is insufficient. And collateral that is pledged once can be pledged over and over and over (collateral chain). So, even though credit increases, the total amount of banking reserves on deposit at the Fed remains unchanged (though composition across banks may change).

So if the banks and shadow banks can just as easily repo their Treasury and mortgage holdings to finance lending, and there is no link between base money and credit creation, why is the Fed doing QE in the first place?

By keeping rates low well out the yield curve and providing comfort that the Fed will be there to fight the risk of recession and deflation, it creates an environment that enables, over time, a normalization of risk taking in the real economy. Our revealed belief is that the Fed can chop these nastier outcomes off the left-hand side of the distribution. As a result we start feeling better about putting our getting our money back out of the mattress and putting it back to work.

Risk taking always starts in financial markets, but eventually bleeds it way into the real economy. And, if you listen carefully, you can hear over the pitched squeals of fixed income investors, who are suffering from sticker shock and low yields, that this is exactly what’s transpiring. The time bought with aggressive monetary policy is allowing household balance sheets to the labor market to slowly heal. Heck, even the fiscal position is rapidly improving.

Again, it is important to underscore that it is the indirect psychological effects from Fed support and the low cost of capital—not the popularly imagined injection of Fed liquidity into stock markets—that have gotten investors to mobilize their idle cash from money market accounts, increase margin, and take financial risk. It is our money, not the Fed’s, that’s driving this rally. Ironically, if we all understood monetary policy better, the Fed’s policies would be working far less well. Thank God for small favors.

This is not a semantic point. I can hear traders saying “yeah, whatever, who cares, don’t fight the Fed, just buy”. But this concept has huge implications for the phase where the Fed decides to remove the training wheels. If the Fed money is not directly propping up the stock market and the economy underneath has been healing, the much talked about wedge between “Fed-induced valuations” and “the fundamentals” is likely considerably smaller than the consensus seems to think. It’s less “artificial”. In short, what all this means is the day the Fed lets up off the gas might give us a blip, or maybe that long-awaited correction, but ultimately the Policy Bears will end up getting crushed, again.

The other, more mechanical, implication is that financial sector lending is neither nourished nor constrained by base money growth. The truth is the Fed’s monetary policy can influence only the price at which lending transacts. The main determinant of credit growth, therefore, really just boils down to risk appetite: whether banks and shadow banks want to lend and whether others want to borrow. Do they feel secure in their wealth and their jobs? Do they see others around them making money? Do they see other banks gaining market share?

These questions drive money growth more than the interest rate and base money. And the fact that it is less about the price of money and more about the mental state of borrowers and lenders is something many people have a hard time wrapping their heads around—in large part because of what Econ 101 misguidedly taught us about the primacy of price, incentives and rational behavior. If you answer the behavioral questions and ignore the endless misinformation about base money—even when it’s coming from the titans of finance—as an investor you’ll be much better off.

2s-10s, the update

Mon, 06 May 2013 08:37:18 -0400

I’ve written a couple of times already about the yield spread between 2s and 10s being an excellent contemporaneous indicator of risk appetite in equities. Macro guys look at a variety of “flattener/steepener” indicators, but this one is the granddaddy. It is something stock-jockeys often overlook.

The downdraft that started in March presaged the April volatility. It is a tribute to market strength that we only got volatility and not a more meaningful sell off.

It is now turning up. It’s worth you while, IMO, to sit up and take notice.

You Don’t Really Understand the Carry Trade, Do You?

Sat, 04 May 2013 12:05:00 -0400

This is the question I always fantasize an insightful CNBC interviewer will ask of his/her guest after the guest offhandedly mumbles something about ‘the yen carry trade’.

Odds are, though, it’ll never happen.

What is a carry trade and why is it so pervasively misunderstood?

First, a quick bit of history (Quick. I promise).

Back in the mid-90s it became increasingly clear that the BOJ was going to become much more aggressive in the battle against Japan’s deepening deflationary pressures. This unleashed monetary experimentation that eventually brought us concepts like ZIRP (Zero Interest Rate Policy) and QE. Fun stuff.

This produced the following investment backdrop: Japanese rates quickly going to zero, US rates north of 5 percent, and influential economists (including He whose name cannot be uttered) exhorting Japan to induce yen depreciation to reverse inflationary expectations. With this scenario, what was a hedge fund to do? Short the yen against the US dollar. In size.

Not only could you expect yen depreciation, but the large interest rate differential gave the trade a sizable tailwind, or, as fixed income guys refer to it, positive carry. On this position, the yen would have had to move against you (appreciate) 5 percent per year to breakeven. This led, over the 1995-98 period, to a move in USDJPY from 80 to 140. Since the positive carry was a sizable part of the ex-ante total return, it soon became known as the yen carry trade. (Side note: the memory of the move from 80-140 is behind much of the hedge fund community’s enthusiasm for the long USDJPY position today.)

But this yen carry trade was largely unknown outside of practitioners until 1998. Up until that point it was the purview of secretive hedge funds and fixed income wizards. The smart guys. However, that year, triggered by the Russian default, markets saw a disorderly unwind of the considerable risk built up in the previous few. From Russian GKOs to Danish mortgages to NJA currencies, it seemed everything was “funded” by a short yen position. Long-Term Capital Management—and the Wall Street prop desks that saw their trades and copied them for their own books—was at the center of much of this. But many, many others, notably Julian Robertson’s Tiger Management, experienced enormous pain.

The phrase ‘the carry trade’ soon became common parlance in finance. So common, in fact, that these days any time anyone shorts the yen—or any currency with below average interest rates for that matter—it gets referred to by some strategist or equity investor as ‘the carry trade’.

People say this because: one, it vaguely fits people’s memory; two, jargon makes people sound ‘in the know’ like the smart guys; and, three, to the legions of those still consumed by their anger at the Financial World it is laden with all the right pejorative connotations—secretive speculators blowing up our world.

But it is wrong.

Think about it. Who has lower interest rates today, the US or Japan? Right. There is no carry there. How about Europe vs. Japan? Right again. Investors short the yen because they are betting on yen depreciation. Carry plays no role.

What, then, do the pros consider a carry trade? The calculus is really simple. If, when you establish the position, the majority of your ex-ante return comes from the interest rate differential between the asset you short (this can include cash) and the asset you go long, then you are putting on a carry trade.

This implies that the price volatility of the paired trade is low RELATIVE to the interest rate differential.

Example: if you buy the Australian dollar against the US dollar, the interest rate differential these days is about 3 percent. Not a lot of carry. The volatility of the pair these days, while very low by historical standards, is still about 10 percent. This means your return will be dominated by the appreciation/depreciation of the pair, not by the carry. You can say this trade has positive carry to it, but you cannot call it a carry trade.

The classic carry trade in currencies came from the days where many emerging markets had pegged FX regimes and high interest rates—due mostly to shallow financial markets and lack of policy credibility. But those days are mostly gone. There are very few true carry trades left in the currency space. Currency volatility relative to potential carry is just too high. The only real carry trades these days are in credit—like them or not. And with low policy rates and steep yield curves in the main financial markets, some of them are quite attractive. Carry on!

Everything you think you know about the Fed is wrong

Mon, 22 Apr 2013 12:47:00 -0400

by Mark Dow and Michael Sedacca

Few would still argue against the assertion that the Federal Reserve has been central to the financial stabilization and economic recovery from the 2008 crisis. They fixed the plumbing and are now trying to incentivize animal spirits to pump water through the pipes. The debate has now migrated to exit strategies and whether growing side effects from exceptional monetary accommodation outweigh incremental benefits.

Nonetheless, it is the Fed, views are heated, and many misperceptions persist. The concept of money printing resonates strongly and intuitively with almost everyone, but most of the intuitive reactions to the Fed’s QE are turning out to have been wrong. Here are some of the major ones that linger.

1. Money printing increases the money supply. The Fed does not control the money supply; they control base money (or outside money), which is a small fraction of the broader money supply. In our fractional reserve system, the banks (loosely defined) control the other 90% or so of the money supply (a.k.a. inside money). And the banks have not been lending. This is why the money supply has not grown rapidly in response to years now of QE.

2. QE is “pumping cash into the stock market”. The truth is little of this money finds its way into the stock market. When the Fed implements QE, they are buying low-risk US Treasuries and agency mortgages from the market, mostly from banks. About 82% of the money the Fed has injected since QE started has been re-deposited with the Fed as excess reserves. With the remaining 18%, banks have tended to buy other fixed income assets of a slightly riskier nature—moving out the risk spectrum for a bank doesn’t mean jumping into equities, especially given the near-death experience that most of them have just gone through.

Of course, not all of the USTs and MBS were purchased from banks. And some of the money does end up in equities. But, really, not all that much. The other big holders of USTs/MSBs who’ve been selling to the Fed for the most part have fixed-income mandates too, and they are also unlikely to take the cash from the Fed and cross over into equities with it.

So, the natural question is why—if the above is true—have equities gone up so much in response to QE? The simple answer? Psychology and misconception.

By taking an aggressive stand, the Fed signaled to markets that “I’ve got this”. The confidence that the Fed would do everything it could to protect our economic downside stabilized animal spirits. Then it slowly but surely enabled risk taking to re-engage. The fact that so many people believe that the Fed would be “pumping money into the stock market” and so many buy into the aphorism “don’t fight the Fed” (notwithstanding September 2007 to March 2009) made the effect that much more powerful.

In short, this largely psychological effect on markets—one that I (Mark) had initially underestimated—bought time for household balance sheets to heal and is allowing fundamentals to catch up somewhat with market prices.

3. QE will create runaway inflation. “Yet” has become the favorite word of the inflationistas. As in, “Oh, it’ll come, just hasn’t yet”. And the magnitude of that expected inflation has been dialed down from ‘hyperinflation’ to ‘high inflation’.

But some continue to hang on. The most extreme inflationistas insist that it is here now and the Fed is cooking the books. The reality, of course, is the Fed has nothing to do with the compilation of US inflation statistics, which is done by the BLS. Moreover, for those who are worried that all departments of government are conspiring against the American people, you would also have to believe the MIT is in on it too. MIT runs the Billion Price Project, a means of testing, using broad-based internet price sampling techniques, the extent to which the government’s measure of CPI reflects reality.

But, there really has been no inflation, even with rounds of QE and interest rates stuck at zero. What we have learned in this crisis has driven home the points that the lending and borrowing that drive the money supply are more sensitive to risk appetite than they are to the price of money.

Is it possible that this will end in a bout of inflation? Yes. But the odds are lower than consensus had been thinking and they are dropping—fast , as inflation continues to be well anchored and people come to understand better how the transmission mechanism of monetary policy actually works.

4. QE is the reason we have high oil/gasoline prices. This very deeply-held view is just as deeply mistaken. As the chart below shows, post crisis/post QE, oil prices on average (red line) have gyrated around 80-90 dollars per barrel with no ascending trend. The ascending trend came well before we knew what QE even was, in the 2002-2007 period. And the most rapid phase of its rise took place as the Fed was raising rates from 2004-2006.

Paying high prices makes all of us angry, and it feels good to have someone to lash out at, but, alas, reality disagrees.

What, then, caused the rise in the price of oil? In brief, the rise of China after it joined the WTO in 2002 and investor allocations to commodities as a “new asset class”, with trend followers, speculators and prop desks front-running the pack. Remember this was a period in which leverage was building and speculative juices flowing full steam.

In any event, it’s pretty clear it was not a result of the Fed and QE.

5. QE has debased the dollar. Good luck convincing people this hasn’t been the case. This is an excellent example of repeating a falsehood until it becomes accepted as true.

Again, roll tape…

This is the trade-weighted broad-dollar average. It, much like the oil chart above, shows all the action took place before QE and the crisis. From 2002 to 2007 the Big Dollar, as currency specialists like to call it, depreciated some 20%. And the fastest depreciation came…that’s right, when the Fed was raising policy rates. Since the crisis the Big Dollar has been roughly unchanged, with gyrations suspiciously similar to oil’s.

Bottom line: Anyone alleging debasement is working from hearsay and priors, not the scorecard. And there are some pretty high-profile people still throwing around the ‘debasement’ word.

In fairness, the Fed did assume that their exceptional monetary accommodation might result in some depreciation of the dollar. But because the US is a closed economy (exports and imports make up a relatively small share of GDP) the Fed felt—correctly in our view—that it should be setting monetary conditions based on the larger domestic economy. And if dollar depreciation were to ensue, so the thinking went, it would at the margin be positive for US growth, as long as the depreciation was orderly.

Why, then, did the dollar depreciate so much in the 2002-2007 period? Pretty much the same reasons as with oil: it was a period of risk-taking, leverage and deepening optimism regarding emerging markets. All three factors led to dollar selling—well before QE ever made its first appearance in the US.

In sum, much of the received wisdom surrounding the Fed and the effects of its actions is misplaced. Through repetition and ex-ante biases, deep misunderstandings have become ingrained in market psychology.

Importantly however, the recent rise in the dollar and fall in commodities suggest that these long-held misguided views are becoming dislodged. There is plenty of risk ahead and the Fed’s task is far from easy or over. But the Fed, for the most part, is ahead of the curve. Make sure you and your views don’t get caught behind it.

Video: Introspection - 2010 vs. now

Sun, 21 Apr 2013 15:17:02 -0400

Every once and a while you have to go back and see how your views have held up. Good traders do this as a matter of course. Economists, well, not so much.

This interview, with @aarontask from July 2010, covers economic views ranging from QE to fiscal austerity, to deleveraging, growth and comparisons to Japan.

Bottom line: I underestimated the psychological impact of QE2, but the rest holds up okay. If you are vapid enough to be interested in my economic babblings, this is as good as any tour d’horizon of the economic mechanics I work from.

http://news.yahoo.com/video/dailyticker-26418594/bernanke-s-bullets-are-blanks-mark-dow-says-the-fed-is-pushing-on-a-string-26419321.html

Gold and Silver – where do we go from here?

Mon, 15 Apr 2013 23:03:00 -0400

Before I start, I want to send wishes and prayers to Boston and my many friends there. I went to graduate school in the area, and my wife and I lived seven years at 780 Boylston Street, on the same block as today’s fateful blast. There are no words…

There’s another preliminary point I want to make. It is my view that gold is a deeply flawed investment vehicle that will hurt a lot of retail investors, investors who have listened to the predatory promoters with business models designed to stuff these investors with their products. I very much sympathize with those who have lost and will lose money due to this bad investment. It happens; we all get things wrong—sometimes dramatically. I can only hope the retail trapped longs have a risk management exit strategy and that they don’t override it.

Where I have no sympathy whatsoever is with the charlatans and hucksters. For them I can only wish pain. It’s too bad too many of them have already taken out enough fees and commissions in this gold bubble to set themselves up for life. But they are not going to get any of my sympathy when their businesses crumble, just as Countrywide, New Century and the like crumbled after their bubble popped.

So, with that, where are we now?

Up until last Friday we saw a steady and somewhat orderly decline. Tourist macro with the big positions (Einhorn, Loeb, Klarman, Paulsen, etc..) and commodity funds getting redemptions were the sellers. On the other side, retail investors continued to buy.

I stole the chart below from J.C. Parets’ write up of the MTA 2013 Symposium (h/t Josh Brown). It shows the retail buying as the professionals began to sell. The total ETF gold holdings continued to climb higher as gold prices went sideways. Even a tourist technical analyst like me knows what that means. I also know first-hand that mutual funds have been seeing inflows into gold funds as recently as last week.

All this ended on Friday, when, as I read the psychology and price patterns, we entered the acceleration phase of the decline. Nothing shakes emotions like speed. Those who thought last week they were seeing a buying opportunity suddenly froze: neither buying nor selling. And pros are not going to initiate shorts here. So, all that leaves us with is a handful of intrepid true believers and short coverers on the bid side, versus forced sellers on the offer—either because risk management is forcing them to do so or the margin clerk is. Either way, no one is selling down here because they want to.

I do expect that once the forced sellers at this level are spent, we will see a bounce. I think this starts tonight or tomorrow. Once the bounce plays out it would be a good time, IMO, for trapped longs to exit and those who share my thesis to re-establish shorts.

I think the Great Unwind of the over-accumulation of “real assets”—especially precious metals—has a long, long way to play out. Remember, this was only the first day that retail even had a chance to sell since they stopped buying last week, whereas the accumulation was years in the making.

Let me trot out a couple of charts. I did these charts on Saturday, in the hope of writing something sooner, but today’s price action has only strengthened the case.

Here’s a 10-year chart of the GLD. It looks like a massive top. The hope that it was forming a basing wedge or whatever was dashed by the price action on Friday. This chart looks like the top is in and it could fall a long, long way.

Some of you might be tempted to suggest that this “consolidation” doesn’t look much different than the one you can see in 2008 (above the lavender arc). For argument’s sake, let’s pretend they are similar.

In 2008, gold fell from the blue line down to the support represented by the red line. The red line is the base from which gold broke out in 2007, and hence, support. If a similar consolidation were to happen today, gold would fall back to the base from which it broke out in 2009—the blue line. That level is 100 on the GLD and about 1000 on gold futures. This would not be a comfortable consolidation to try and ride out from here.

But 2012-13 is not 2008. Back then, we were in crisis mode, with no clear bottom to our economy in sight. Inflation emerged as a big fear once the Fed started expanding its balance sheet aggressively in late 2008.

Today, we are on the back side of all that. The economy continues its anemic recovery. Inflation is really only a worry for the tin foil hat crowd. Joblessness is still very high, but it is grinding the right direction and household balance sheets have come a long way. The financial position of our financial and corporate sector is far, far better. In short, there are still fears, but they are fewer and less life threatening. This, plus the positioning and the fresh shift in psychology, will make it hard for gold to find a durable bottom anytime soon.

Again, here’s a clean chart of gold futures going back 14 years. Even my friends who are ideologically predisposed in favor of gold said this chart is a massive top.

Good luck.

2s-10s: be vwery, vwery afwaid

Wed, 27 Mar 2013 13:37:00 -0400

Remember this post back in January? It said, inter alia, to watch the spread between the yield on the US 10yr note and the 2yr. It suggested something good was happening (US healing) and that we should all take note.

Here’s the chart today:

It doesn’t look so good for risk taking. It doesn’t mean the world will end, or that you have to join the Policy Bears in the bunker, but it means you have to protect yourself.

It also means I have to be careful with my precious metal shorts.

Looking to add equity risk but are afraid at these levels? Look to copper and the Commodity Unwind

Tue, 05 Mar 2013 14:12:45 -0500

What we are seeing in the commodity complex is the drip, drip, drip of orderly liquidation. Commodity funds are losing assets and/or being shut down. Tourists who ventured into commodities to protect against macro fears that didn’t materialize have started to sell. And the sell-side commodity hype machine is now behind us. This is why commodities have stayed so oversold for so long with high negative sentiment readings, yet still go down pretty much every day.

When performance is dragging, less experienced traders often lock in profits on their winners and double down on laggards. The pros, however, prune their losers, and pros are the big holders of commodities. Hence, the drip, drip, drip. (NB: liquidations usually start with drip, drip, drip and end with flush.)

How far does the unwind have to go? These things are always hard to say with precision. But what we do know is that the commodity unwind should be a function of the size of the build-up—plus a reverse-bubble psychological dynamic once the selling gets going. Rapid rate of change influences emotion much more than level.

Since I believe the buildup was significant, with a good portion of it predating QE, I expect the unwind to be large and sustained. But, ultimately, every investor/trader has to come to his/her own determination of how big the unwind will be.

Do you think the US has put crisis behind it? This is really the only question you have to consider when you look at the above chart of gold since 2000.

What we have been seeing is that silver and gold are developing an increasingly negative correlation with the S&P. And it is in the precious metals where most of the tourist dollars reside. So hedging your equity longs with silver and gold—though it has worked very well for the past few months—will become more painful to hold onto in countertrend days, and possibly brutal in a selloff (both your longs and shorts may well move against you). It you have a cast-iron stomach, you should be fine. The reality is, however, that most of us don’t—and hanging on to a winning trend is the single hardest skill to learn in investing. A better hedge will help you do that.

Enter copper. During the speculative run on commodities, there was a lot of broad allocation to the asset class as well. This means copper (and to a lesser extent oil) will correlate in part to precious metals, and in part to the S&P, since, as an industrial metal it is more sensitive to growth. The bottom line: copper right now makes for a better macro hedge than silver or gold.

The point of this is that if you have been suffering from being underinvested and you are looking for a way to add stock risk to your book, a really solid way to do it that minimizes the risk of being the goat in two months’ time is to buy the stock you like based on your process, and hedge the beta out by shorting copper. It sensitivity to growth should make it go down on down equity days, but on up days it should lag—or even outright decline—based on the drip, drip, drip of the commodity unwind.

Here’s the chart of copper of the same time horizon, FWIW:

AAPL and Gold: Still all about Bubble Psychology

Mon, 04 Mar 2013 14:03:08 -0500

Apple and GDX, the ETF for gold mining stocks have very little in common—or so it would seem. One is a major technology stock, the other, a leveraged play on precious metals. Apple has tangible value, which at some price point will matter; Precious metals have whatever value we assign to them—the ultimate greater fool trade.

But the chart below shows a striking similarity. Both have been highly correlated to the downside in an overall up market.

Why? A tale of two bubbles. Both were the objects of excessive enthusiasm. This enthusiasm is now unwinding. My guess is that AAPL is close to finding a bottom. Precious metals—where there is no tangible anchor—look set to go much, much further.

The other interesting observation is the evolution of the rolling correlation between AAPL and the SPX. One thing to watch for is this correlation picking back up—implying the idiosyncratic component of the AAPL unwind is mostly behind us.

Framework for Thinking about the Buck: It's an Overhang, not a Hangover

Fri, 22 Feb 2013 10:41:00 -0500

This was originally written for a blog over at the CFR. The framework is still useful today, IMO. At least you can compare it to how things have kind of turned out. Here is the link to the original.

The Dollar: It’s an Overhang, not a Hangover

By Mark Dow
July 6, 2009

Few things are more confounding to economists and traders as forecasting currencies. However, as I have come to realize, the approach each group takes is very different. Economists are never wrong, only early; traders are often wrong, but never in doubt. Economists look at interest rate differentials, growth differentials, current account positions, and other fundamental factors. It doesn’t always help much, but it is a defensible place to start. Traders, on the other hand, cognizant or not, focus not on the fundamentals, but on the “fundamental story”. These stories typically emerge to fit recent price action and are then coupled with what economists refer to as stylized facts. Unlike facts, stylized facts are not stubborn things. Some stories turn out to be true, others false, but whether they are true or not the most powerful ones share two characteristics: they are easy to explain and intuitively appealing. And once a good story takes root it can be very difficult to dislodge it—irrespective of how untrue it may be.

“Stories” that drive the dollar abound. They are usually easy to explain and intuitively appealing. Most of them turn out to be wrong. Excessively low interest rates in 2003, the Fed “printing money” today, large current account deficits, increasing budget deficits, Chinese concerns, all of these are given ample airtime. In short, the core story we have been hearing is that the dollar is now suffering a hangover from the fiscal, monetary and external account binge it has been on in recent years.

How well does this hangover story hold up? Not well.

First, dollar weakness has not been as dramatic as the story that has accompanied it. The only big decline came in 2007 (red arrow in the chart below) when the world was in massive risk seeking mode, loading up on carry, reaching for yield, constructing CDOs and CDO-squareds, and using the dollar as a funding currency. Much of this decline was unwound over the past year as the world began to deleverage. In fact, the dollar is right about at the same level as it was when Lehman went bankrupt.

Second, much of the story centers on the Fed’s expansion of base money. This is wrong on many counts. To begin with, the Fed is not printing as much as you might be led to think from listening to financial commentators on TV. Base money (here) has been flat lining since early this year (total liabilities are in the leftmost column). Moreover, the money multiplier has continued to decline, as credit is destroyed and the private sector delevers. (I think many commentators end up confusing base money with the broader money supply, but there is no need to get into this now). In addition, when the expansion of base money was truly rapid, from September to December of last year, the dollar was getting stronger. Why? Because that’s when the demand for dollars was strongest. Memories of Econ 101 and quotes from Milton Friedman have encouraged an excessive focus on the supply of money, when the real driver has been the sharp changes in demand. As funding pressures in the financial system eased, the dollar started to decline again. It is not a coincidence that the DXY (dollar index) made a high in early March when the S&P made its lows. Lastly, there is an article in this week’s Economist, pointing out how the ECB has been as expansionary as the Fed, but have been lower profile about it. But I haven’t heard any talk about the debasing of the Euro. In sum, sexy though the story might be, I don’t think the “Fed-is-printing-money-like-Zimbabwe” theme is really driving anything but the psycology of a few.

What about the current account deficit? No one home there either. As soon as the deleveraging accelerated, the US current account took a sharp turn northward. In the chart below I use the trade balance, which comes out monthly, as a proxy to capture the rate of change.

Ultimately, the current account story is much more a credit story than an FX story, in my view. And it is fixing itself without much help from the exchange rate. In fact, as you can see above, the increase in the trade deficit coincided pretty well and pretty monotonically with the great credit bubble in the US. So it shouldn’t surprise us that the decline in credit reverses it. (This also has implications for the need for foreign purchases of Treasuries, which has been cited as another concern.)

Fine. If these stories are wrong, does that mean I am bullish the dollar? The answer is no.

The dollar has an overhang problem.

For the past 60 years the dollar has been the only game in town. It was the lubricant for financial and trade globalization, the undisputed store of value in the international monetary system and the primary medium of exchange/unit of account for commerce. The world held more dollars, and the world transacted more often in dollars. Demand outside the U.S. for dollars grew rapidly for many, many years. For monetary balance inside the U.S. to be maintained, the Fed had to provide these dollars; otherwise interest rates at home would have been much higher.

Fast forward to today. The world has undergone a radical transformation. Abstracting from the current global recession, most countries across the world are in much better economic shape than was the case 15 years ago, and their currencies are more stable and increasingly more freely convertible. People trust their own currencies more, as well as the currencies of other countries. Dollar holders — central banks, sovereign wealth funds, international corporations and individuals alike — realize they have accumulated too many dollars over the years. Holding such a high percentage of one’s precautionary balances in dollars no longer makes sense in today’s world. Not because the dollar is bad per se, but because there are so many opportunities to diversify safely.

Mexicans no longer have to keep as many dollars under the mattress. Brazilian companies no longer need to keep a war chest of dollars hidden in the Cayman Islands in order to ensure access to imported inputs. Sovereign wealth funds have realized that it is neither wise nor prudent to keep so much of its stock of wealth in one currency. Investment management firms are starting to offer more non-dollar share classes for their products. And Italians, Poles, and Turks — peoples closely linked in one way or another to the euro — are thinking less and less in dollars (it is amazing that they still do at all).

The transactional demand for dollars is also declining. This too puts downward pressure on the dollar. In countries like Brazil and India, hotel bills used to be presented in dollars. Not any more. Cabs in emerging economies used to prefer payment in dollars. Now it’s not worth the hassle. Many countries that historically quoted real estate prices in dollars are doing so less and less. Bilateral trade, on an ad hoc basis, is ever more frequently eschewing the dollar for other currencies.

With the demand for dollars structurally falling, the dollar should face headwinds until currency stockpiles have adjusted and a new equilibrium is found. With some 70 percent of dollars in circulation held outside of the US, unwinding this overhang may take a long time. This doesn’t mean we can’t have vicious countertrend rallies in the dollar. Every time risk aversion gets intense enough, the dollar tends to do exactly this. But it does suggest that you can expect the dollar to be undervalued relative to any intertemporal, goods market concept of its underlying value for quite some time.

The Case against Commodities and Emerging Markets

Wed, 20 Feb 2013 22:50:00 -0500

Commodities as a group have been underperforming equities for about six months now. The correlation between the two groups has been grinding lower. Even more important, I think the underperformance of commodities—and by extension emerging markets—will persist for some time.

Hang on. If the backdrop is improving growth expectations and continued, if not increased, global central bank base money expansion, why have they underperformed and why should it continue? Here’s my answer.

Misunderstanding Monetary Policy

This is going to sound bad so I’m just going to say it: Most investors and commentators have a deeply flawed understanding of monetary policy. Very few have any direct experience in this complex issue area. Many equate printing money with the money supply. They think changes in base money drive currencies. Most haven’t internalized that the money supply in a modern monetary system is endogenous (i.e. created by banks and risk appetite, not the central bank).

It is for these reasons people feared inflation, higher Treasury yields and a collapse in the dollar in response to the Fed’s exceptional measures. Remember stagflation? Me neither. None of these things happened.

People are now catching on to this. The percentage of investors who now think the Fed balance sheet will provoke a new crisis or that the ONLY possible solution to the US debt is inflating it away has shrunk considerably. This reduces the demand for hard assets.

Pavlov’s Oil

Many may have forgotten by now that the first massive wave in commodities was in 2007-2008, back before we knew what QE was. The story then was China and the Emerging Markets were rapidly plugging into the grid, set to consume our finite reserves with their vertiginous growth trajectories.

Subsequent boomlets in commodity prices, the ones that came post-crisis, were linked mainly to monetary stimuli and the flight into hard assets.

Together, this imprinting led us to reach for emerging markets and commodities any time we had a risk-on phase. In this last phase people have again reached for commodities and emerging markets to express their bullishness, but I’m suggesting this time they are setting themselves up for disappointment.

The first reason is that the emerging markets have downshifted their rate of growth. Some even have their own processes of credit digestion to contend with. Moreover, before the downshift we feared EM could grow to the sky, leaving many of us guessing at how intense the competition for scarce resources would become. We now have a better handle on “how high is high”.

Second, we have been coming around to a better understanding of monetary policy. We now increasingly get that the effects of monetary policy will be largely psychological and transitory until the deleveraging process approaches completion. At least, I hope we do. Otherwise, the fall in commodity prices will be deeper and the pain trade will last longer.

These developments will, eventually, reprogram our reaction function. The days where we’d say, as someone else recently put it, “it’s going to be a risk-on day, let’s buy 200m AUD”, are likely to fade further and further into the recesses of our memories.

Beware the Hype Machine

When the sell-side makes “a thing” out of an asset class, there is usually considerable downside and unwind at some point ahead. The length and depth of the downside is typically a pretty clean function of the length and breadth of the hype. And in 2011 commodities became a thing.

Sell-side firms were sending team after team of analysts and strategists to explain exotic commodity trades, often to hedge fund managers who had no experience in them. Buy-side firms started to scramble to build their own teams and launch new strategies. John Paulson was still in hero mode and he was buying gold, thus giving cover to others’ hubris. And, of course, the gold ads on television were busy shifting into a higher gear. I could just close my eyes at night and hear the sound of central banks printing money.

The apex came in the spring 2011, a month or two before the final parabolic burst in silver. The Morgan Stanley commodity specialist came in to visit with his 8-man team. When he recommended, as his best idea, a pairs trade “long rhodium and short molybdenum” (really, I’m not kidding), I knew that the time for shorting precious metals would be soon upon us.

The bottom line: the speculative demand for commodities is likely to become less robust over time, and the growth rate of emerging markets more modest and definable. We are in the midst of the process of pricing these factors in. And the good news is the decline in commodity prices need not presage a collapse in global growth if it is mostly a function of a slow unwind of past excesses and the market’s previous monetary miscalibration.

Cash Hurts--but so does Crash: Market update

Sat, 16 Feb 2013 21:21:00 -0500

A friend of mine from London (a currency-oriented macro guy) with whom I regularly exchange ideas asked me my views this morning. I’ve posted my side of these exchanges before. Here’s the latest:

I think the story with gold/silver is the same one we’ve been discussing since May 2011. The fever peaked (with the parabolic silver spike), and now we realize that (1) monetary easing isn’t as powerful as the markets had been thinking and (2) all the “tail-risk reasons” for owning gold and silver are melting away. And it is still a crowded trade amongst the macro tourist crowd that hate US monetary policy, but, when you read what they write, clearly haven’t understood it (e.g. inflation, higher yields, US-is-Greece, pick your variant). Think Einhorn, Loeb, Paulsen, Dalio (though Dalio’s not a tourist), etc.

In short, the monetary tables are now turned: it’s not Bernanke who needs an exit strategy, it’s them.

The framework I finally got around to laying out in June last year goes through things factor by factor. It seems as relevant now as it was then—at least to me.

More broadly, I am bullish, structurally. Growth will be mediocre, with scope for upward surprise only in the US—and even this would be modest. Plus in the US we have to slog through a fair amount more of fiscal drag. Growth everywhere else is not great, and in Europe it’s downright terrible. There is not enough lipstick in the whole Sephora chain for the PIIGS, and I expect more downside surprises—both with respect to depth and duration, but at least the surprises should now be of a lesser magnitude.

We will likely have risk hiccups out of the Old World, but the end game there (re-memberfication of the euro—I know, not a word) will be further out in time and only after years of economic contraction bring radical political alternatives more solidly into the mainstream. For now these forces are still dancing around the fringes.

But, for the medium term, I think low-ish but steady global growth is good for equities. Notice below how the amplitude of the surprise index swings post-crisis has been contracting. Textbook disaster myopia. Bottom line: People will need to take risk. Multiples should expand. Dividends are still a draw. Cash hurts.

I have been long equities (admittedly a little slow in jumping back on after getting off end-December) and short gold and silver. I haven’t needed to trade much. I took down equity risk on Friday for the first time in a while. I don’t like what I see in the European indices of late and if gold and silver accelerate further to the downside (which is my base case) the old correlation to equities would likely come back, dragging equities down along with the shiny stuff.

The equity market is loaded enough with “late purchases” that it wouldn’t take a huge story to generate a shakeout. A hard fall in precious metals could catalyze such a story. What would that story be? It really doesn’t matter much; we market participants always reverse engineer something plausible whenever we see sharp price action.

I am holding core long positions, now partially hedged with European “stuff”—in addition to the precious metal shorts. I hope we get a selloff in the next month or so, so that I can increase equity exposure. I suspect I am not alone in this, which of course complicates my odds of being right. If the selloff in precious metals accelerates too much I will probably trim some futures and sell some puts against a good part of the rest. But sooner or later—who knows when?—we are going to get a whoosh-type selloff in precious metals for the reasons outlined in my framework, so it’s very unlikely that I would take my exposure to zero. In my dream sequence, I am hoping that the market will let me keep my long equities, short precious metals positioning for the bulk of this year if not longer.

Update of the Structural Bear-killer post

Wed, 13 Feb 2013 08:11:00 -0500

Late in January I was worried about having been too cautious since end-December yet too late to the party to add risk. I posted some charts showing that the odds were decent that the shift afoot was structural in nature, unlike the stop and go markets of the past two years. These charts made me more confident to go with the flow. Here is an update of those charts. And, sadly for the Policy Bears, the song remains the same.

The 2s-10s steepener trend looks robust, not tired. A great sign for risk taking.

EURAUD and EURCHF are signs of financial normalization. Don’t worry that AUD is considered a growth currency (more on this below), the bigger signal is that people are crawling out of their bunkers.

Mortgage rates (above) look set to go higher. Wait. Isn’t this bad for housing and therefore for the overall US recovery?

Answer: no, for two reasons. One, from a financial point of view it shows investors are moving out the risk spectrum. And two, price hasn’t been holding buyers back. Down payments, job security, and tighter lending standard have. Levels are still plenty low enough for solid borrowers who can make the down payment to buy.

If indeed this is the structural shift in risk taking that it appears to be, it will be more about normalizing financial risk appetite than a rapid acceleration in growth—either here in the US or globally. This means the reflexive reach for commodities and commodity proxies (e.g. AUD) that has accompanied every risk impulse for the past five years may come a cropper this time—particularly since we have seen behind the Great Monetary Curtain and realize the machine is being run by mortals (i.e. The broader money supply is endogenous, and is driven by risk appetite and not money printing).

The portfolio implication for the investor? Structurally long equities, hedged with structural commodity shorts.

Four charts tell a powerful story of where we are. They all say “It’s Structural this time”

Mon, 28 Jan 2013 09:47:00 -0500

Four charts tell a powerful story of where we are. They all say “It’s Structural this time”. Safe Haven Exodus.

Yes, I know a correction could happen at any time. I myself got caught out jumping off the train a little too early back in late December. But longer-term, if you do the impossible and look out over the news cycle, these four charts below tell us a structural shift in risk allocation is afoot. The Policy Bears, the Central Planning Truthers, are either getting tapped on the shoulder or rounded up to be executed. How fitting: Death by stocks.

I am not talking about short- and medium-term positions, the kinds that get picked up in sentiment surveys and overbought/oversold oscillators. I am referring to the structural hedges big, slower-to-move strategic investors have had on to protect against the next macro crash. These massive structural trades—and make no mistake, they are measured by the ‘yard’—appear to be in a fairly early phase of unwinding.

Above is the yield spread between the 2yr and 10yr UST yields, charted on a weekly basis back 5yrs. Moving higher is referred to as curve steepening, and is associated positively with growth expectations and risk taking. If you think about where this spread was in 2011 and how much better we feel about today’s economy and financial landscape, this spread could easily get back to well north of 200bps.

Another structural Safe Haven position has been to be short EURCHF. In size. Long CHF and short EUR. The reasoning is clear. Europe bad, Switzerland safe. I don’t think Europe is anywhere near out of the woods, but between the LTRO and the OMT, they have “merely” a growth problem now—or, at least for the next year or two. Rightly or wrongly, people are assigning a higher probability to Europe muddling through, causing the macro monsters to unwind the flight-to-Zurich trade.

A first cousin of the EURCHF position is short EURAUD. Again, the logic is clear. Europe has no growth prospects and risked imminent financial meltdown. AUD, on the other hand, lives where the growth is, with a commodity kicker/China play thrown in. It has also trended for a long time, suggesting that a lot of trend following CTAs and hedgies have been riding it. The chart here two, suggests this trade too is now in the early phases of getting unwound.

Lastly, a more exotic version of these Safe Haven positions is Short TRYZAR. This, too is unwinding. This trade is trickier because there are idiosyncratic moving parts in both countries, especially South Africa. But it does reflect global normalization from crisis mode coupled with modest growth. It also suggests, as do the 2s10s steepener and long EURAUD, that commodities will not bounce back as forcefully as they have in the past few years on bouts of risk appetite.

But I should finish by being clear about my views: Don’t confuse me with a growth bull. Both the developed and developing economies have “digestive” issues they need to grind through, and economic expectations have improved to the point that when fiscal drag in the US starts kicking harder there will be room for disappointment. But the incipient unwind of these positions is nonetheless a strong long-term positive. It tells us a broader investing audience is, in deed and not just in word, coming around to realizing the next financial calamity, the Lehman II, that lurking “Other shoe”, is just not on the horizon.

Surprise! (index): Update

Fri, 11 Jan 2013 10:16:40 -0500

On December 16th I posted some trading views, in which I referenced the economic surprise index Citigroup publishes for the US. Here it is, from that date, below:

And here is the update from today:

Remember, a positive reading of the Index suggests that economic releases have been, on balance, beating consensus. So a lower positive number means less positive surprise. It doesn’t mean negative surprise until it crosses zero.

We’re approaching zero pretty fast.

The Effects of QE on UST Yields—Now the Answers Start to Matter

Mon, 07 Jan 2013 11:12:39 -0500

The debate about the impact on US treasury yields from the Federal Reserve’s LSAP programs—often referred to as Quantitative Easing—is raging into its fourth year. In fact, now that the time series are getting long enough for more robust number crunching, I suspect academics are going to really start diving in and begin the writing of history.

Practitioners, however—both policy makers and those of us who have money on the line—don’t have the luxury of time. We are entering a critical phase right now. Why? Household leverage has been the prime impediment to a normal functioning of monetary policy. And it is now starting to get down to a point where monetary policy will start gaining traction. Not a lot of traction, because these processes are slow, but any traction at all means the days of the dreaded liquidity trap are numbered.

So we are now going to have think harder, and in more practical terms, about the counterfactual: where would UST rates be without the exceptional monetary stimuli the Fed hath wrought.

There are two basic camps in this debate, and from where I sit, neither side has it quite right.

One camp says the Fed’s massive purchases of USTs and agency mortgages have artificially lowered rates a lot. Looking at UST yields and spreads throughout the fixed income complex gives them sticker shock. Some fixed income managers are even mad. They fear that this is inducing a misallocation of resources, incenting higher government spending than would otherwise be the case, is hurting savers, and might constitute a new bubble. Many in this camp fear high inflation will follow. Their prediction for when the Fed stops buying? Pain—pain in markets, pain in the economy, and pain in the budget, stemming from the higher UST rates they assume will follow.

This camp comprises much of the professional fixed income asset management crowd, the majority of sell-side strategists, a fair number of economists (e.g. the recent op-ed by Marty Feldstein in the WSJ), and virtually all of the Policy Bears (think, for example ZeroHedge or CNBC’s Ric Santelli).

The second camp claims it is all about expectations, not physical purchases, and that QEs have actually raised UST yields relative to where they would otherwise be. Joe Wiesenthal over at Business Insider was perhaps the first to propagate this view. Others, like Matt O’Brien at the Atlantic and Matt Yglesias at Slate, have more recently laid out the same basic case: looser monetary policy from central bank bond buying raises, rather than lowers, rates because the indirect effect through expectations on future nominal GDP growth is greater than the countervailing pressures from bond purchases.

This camp comprises an increasing number of sharp-eyed financial/economic journalists, some of the more nuanced fixed income veterans, most salt water economists, and a lot of equity managers (who always seem to be on the lookout for a bullish story).

This view is always buttressed by some version of the very convincing chart shown below, in this instance lifted from Matt O’Brien:

In it, one can see very clearly that when the physical purchases of USTs and mortgages were taking place bond prices were indeed going down and yields higher.

Conversely, the moves higher in price and lower in yield happened when the Fed “wasn’t in the market”.

The rationale is simple: the Fed tended to hint at or announce QE programs when the economy and markets appeared to be weakening sharply. The chart shows that even though we were in the throes of a deep in a liquidity trap, the psychological effect of Fed support was strong enough to snap us out of slide into self-reinforcing pessimism and move us away from nastier equilibria.

Okay, that was easy. So, case closed? QE means higher rates, right?

Not so fast. Look more closely at the chart.

The idea behind large scale asset purchases, of course, is that they are supposed to drive down interest rates and facilitate the healing of bloated private sector balance sheets, in our case, in the household and financial sectors. This, in turn, would lead ultimately to a resumption of lending, once the lenders and borrowers have worked themselves back into stronger financial positions.

The theoretical debate has taken for granted that LSAPs lowers rates, and instead focused on the channel through which the purchases would achieve this. Thinking about these channels is important.

First, there is the “Flow” channel. Some academics and most markets participants have been inclined to believe that LSAPs lower rates through a flow effect, that is, through the physical purchases. The intuition here is powerful: sharply increased demand means higher prices, lower yields.

On the other hand, many academics and policy makers—including the bulk of the Fed—believe rates are lowered through a stock effect. That is, asset purchases reduce the available stock of assets, and so, for a given view, the clearing price will be higher (and the yield lower) than otherwise would have been the case. The implication is that this affects, over time, the level of yields, even if the oscillations in yields are driven by other factors, such as economic expectations.

Now, let’s go back and look at the chart again. You will see what technicians call “lower highs and lower lows”. And it’s important to note that this pattern was taking place against the backdrop of an improving economy which would normally push UST yields higher.

This to me means two important things: one, LSAPs have almost certainly over time lowered the clearing rate for UST yields—even though the impulse correlation, driven by economic expectations, has worked in the short-term in the opposite direction.

The second observation is that the “expectations effect” was of lesser amplitude with each Fed announcement, again, against the backdrop of an improving economy. In fact, after QE3, there was virtually no bump at all. This is because sentiment surrounding monetary policy has done a 180 over the past two/three years. Because the shifts in expectations were not subsequently validated by fundamentals, market participants progressively came to view effects from Fed policy as psychological and ephemeral. It went from ‘very hard’ two years ago to make the case that QE wouldn’t be inflationary to ‘fairly easy’ today. Most everyone by now has wrapped their head around the notion of “liquidity trap”.

Two conclusions can be drawn from this. One, the end of LSAPs will matter for yield levels—even if the Fed decides not to sell any of its holdings and let their book run off. So, if you think it is entirely about economic expectations you are likely to underestimate the magnitude of yield “normalization”.

Two, many investors and analysts have settled into the notion that we are in a liquidity trap, and that monetary policy here is largely “pushing on a string”. While this is still for the most part the current environment, it is finally, slowly, starting to change. Monetary policy can be very, very powerful when the soil is fertile. This is not the time to become complacent about the impotence of monetary policy. That time has passed. It may not be tomorrow, but the efficacy of monetary policy has now become, as the economists might say, a positive function of time.

Trading note on Silver and Gold (A quick post from il Bel Paese)

Wed, 19 Dec 2012 09:32:00 -0500

The only asset that can embarrass you faster and more brutally than silver (and to a lesser extent, gold) is natural gas, the nitroglycerin of futures trading. With that firmly in mind, and in light of the recent price action, here are my current thoughts:

My fundamental views about silver and gold are, gulp, on record here and more recently here. What has changed recently is that the impulse correlations of precious metals to stocks, the US dollar, and bond yields, which have been steadily declining for a long time, have now flipped signs.

Despite all the talk about safe haven status in recent years, PMs have had a strong positive correlation with stocks and risky assets more generally. Their correlation with the dollar, of course, has been strongly negative. Less intuitively, the impulse correlation of PMs to treasury yields has been positive, even though low levels of yield (more precisely, real rates) is an important driver of higher PM prices.

These correlations have flipped in the last few days in a way that is apparent to everyone. The decline in gold and silver in the face of a strong bid to risky assets will now likely force people to reconsider their investment hypothesis for holding them. Big events and correlations that change signs often do. Specifically, a lot of big macro tourists hold large PM positions, and what I believe we are seeing is some of them starting to hit the bid. It is also possible that some of them are also facing redemptions, since those clinging hardest to their PM positions are also those most likely to have been working under the wrong economic assumptions and underperforming all year. So, the year-end dynamic may be exacerbating the pressure we are currently seeing

On the technical side, though I am not, ahem, a master technician, it is apparent that gold and silver yesterday broke medium-term trend lines. But I actually don’t think that is unusually significant. As I said before, PMs are notoriously tricky to trade on a short-term basis. I’m sure even the best technicians have great war stories about being fooled by gold and silver. What I think is hugely significant is the 1600 level on gold (Feb 2013 contract). If it breaks below that level I think the warning flare goes up for everyone to see. Gold has rebounded from strong corrections before and may well rebound from this one. But I have a strong sense that if we get below 1600, it will matter in a way it hasn’t in many years, and all (gold) bets will be (taken) off.

Sentiment and trading views, feat. Gold, Silver, AAPL and Mortgage REITs

Sun, 16 Dec 2012 19:06:00 -0500

I am not a consumer of the big, bold predictions and the surprise lists that roll in this time of year. They mostly serve marketing purposes, or as a call option on self-aggrandizement, or our desire, at some level, to be told what to do. But many people like them. Uncertainty—the kind investors face daily—is draining and unpleasant. These things help fill that void. And they give us a reference point against which to calibrate our own views, however uncertain those views may be.

But, at the end of the day, whether you like forecasting or not, we have to make a call. Especially if your process is trading-oriented. Buy or sell. Long or short. Beta or alpha. Bonds, stocks or cash. Investing and trading require us to try to look out around the corner, even if only a little bit, and even if it is only probabilistic. So, with that caveat, this is what I am currently seeing around the corner:

Sentiment

On the Economy. The US economy is steadily improving, but expectations are catching up. You can see this in the Citigroup Economic Surprise Index for the US, which is stalling here and appears more likely to revert than not. (A positive reading of the Index suggests that economic releases have been, on balance, beating consensus. So a lower positive number means less positive surprise. It doesn’t mean negative surprise until it crosses zero.)

On Positioning. The short-term positioning seems to reflect (1) increased recognition of the improving US economy, (2) belief that Europe will remain in recession but not produce a Lehman II, and (3) that expectations with respect to Emerging Markets have finally receded to a place where it makes it safe to put a foot in the water. You can see this in the price action, in some of the sentiment surveys/technical indicators and in the chatter coming from other traders and investors.

Lastly, the discussion of the fiscal cliff seems to have morphed from “I think they get a deal, but I will wait to buy because they are likely to disappoint us first” into “the market will rip as soon as a deal is announced and it is too risky to be out and miss the move”. This changes the payoff structure.

The longer-term positioning, however, still reflects a fairly negative outlook, which is positive. Many investors, still clutching their rear view mirrors, are still afraid to commit to equities. The scars are just too deep.

Then there are the policy bears. They believe government intervention has made all this artificial and at some point “we will all have to pay the piper”. They disagreed with TARP, said the Stress test wouldn’t work, thought QE would be inflationary, asserted big deficits would drive yields higher, believed austerity in Europe would be good for growth, and compared the US to Greece. They have been wrong, underperforming and are increasingly angry. Rather than admitting they were wrong, many are pushing out the timetable for their forecasts to materialize, or quietly walking them back and hoping if the transformation is gradual enough no one will notice. Because when you’re wrong it is hard (and reputationally costly) to change your views. And, behaviorally, constantly questioning your own views requires much more effort than settling into certainty.

This is what the inner monologue of the policy bears sounds like right about now: “if I get long after fighting it for so long and the market turns around my clients will think I am a fool with no process”. Plus, it always sounds smarter to be bearish. And sounding smart helps underperformers hold onto assets.

So, what do they do? They play light, wait to go short, or take repeated stabs at the short side with stops. The takeaway, though, is that at some point they will recognize that below the surface of the policy drugs there is a healing process: household deleveraging. We are already seeing the effects of it. And as this becomes clearer both scarred investors and policy bears will get dragged into the market.

On Monetary policy. Sentiment surrounding monetary policy has done a 180 over the past year or two. A couple of years ago it was very hard to make the case that QE wouldn’t be inflationary as long as the household sector was deleveraging, and that the market effects from it were predominately psychological. I still have the scars from those debates. Using technical jargon like ‘endogenous money supply’, in an attempt to recover some credibility, only got you more dismissive looks.

However, since then, markets have been (for the most part) coming around to this view, and consequently the half-life of a market reaction to the announcement of fresh monetary stimulus has fallen to about zero. This is new.

It has two implications. First, assets that have rallied from the flight into inflation hedges will continue to leak. It is not a coincidence, in my view, that the ‘evolution’ in the understanding monetary policy began right about the time gold and silver prices peaked last year. Ever since, the diminishing market impact of Fed announcements has become apparent to all, and the commodity complex has correspondingly stayed well below its 2011 highs. Yet virtually everyone is still calling for gold to make new all-time highs in the coming year.

From where I sit, many people have crowded into gold and silver (and oil—don’t even look at cotton!) on, inter alia, this flawed understanding of the monetary policy transmission mechanism and this will create selling pressure for quite some time. Will it be enough to offset the diversification demand from central banks and the income effect from the Chinese and Indian markets? This is a harder call, but I think the answer is yes—virtually certain if the recovery in the US gains traction and the Treasury curve steepens. It also bears recalling that central banks since the 80s have tended to be net sellers of gold when prices were low and net buyers when prices were high. So I wouldn’t count on central banks being there below the bid for too long if prices really start to drop. But it really is hard to say whether this will be a drip, drip, drip or something more sudden.

Here’s a crude chart of silver to illustrate how far it could fall if my hypothesis plays out. (I confess: I am Tourist TA.) That support from the parabolic breakout in 2010 would correspond to a futures price of about 20.

The second implication is that just as everyone has bought into the “impotence” of Fed policy, we are starting to see signs of it having an effect. There has been a lot of head scratching and soul searching in the economic community (including Fed governors) about the efficacy of monetary policy. Has the transmission mechanism structurally changed? Are there new features we don’t understand? It is that policy is not aggressive enough?

It seems to me the answer is very simple: pretty much no amount of QE will work until (1) the household deleveraging is mostly over and (2) people feel better about job security and prospects. It is on these two factors that most people set expectations and consumption patterns, not on base money quantities or things like NGDP targeting. Expectations, in turn, set risk appetite and risk appetite drives the endogenous money supply.

And on a small scale this is happening. Prepay speeds in the mortgage market have picked up, indicating more refis, and there is more activity in the primary housing market. Household formation has picked up, too, as young adults are increasingly getting out from under their parents roofs for the second time. The job market, for its part, seems to be grinding in the right direction.

The simple way to look at it is that the Fed’s aggressively accommodative policy didn’t directly cause these things to happen. But by facilitating the deleveraging process, it likely moved forward the date by which households will have their balance sheets sufficiently repaired to normalize their rate of consumption, with knock-on effects to the rest of the economy. We are not there yet, but we seem to be getting closer, fiscal drag notwithstanding.

Price action

I know, I know. Buy or sell? Okay, here are a few more concrete markets observations.

First, it really is a stock-pickers’ market. It’s a phrase I don’t like because it is overused by guys on TV who want to sell you there stock-picking services. Somewhat fitting I guess that just as everyone scrambles to go macro, stock picking seems to be working. On what basis do I say this? Look at the index of implied correlation of the elements of the S&P, to start with.

The implied correlation amongst S&P components has been heading downward all year. In case you can’t make it out, it falls from just above 80 percent last January to just below 65 percent in December. This tends to be both a bullish sign as well as an indication of less ‘macro’ and more ‘stock picking’.

Second, we have seen of late many of the crowded positions underperforming and many of the hated positions doing better. Precious metals and AAPL crop first to mind, but there are many others. And some of the hated positions, e.g. RIMM, NOK, X, have been perking up. I don’t know how long this lasts, but it is the theme for now and it makes no sense to fight it.

While I’m here, let me make a quick, behavioral point on AAPL. AAPL has been THE story stock in the market over the past few years. It has been our collective obsession. It has sucked all the oxygen out of every financial chat room and could do no wrong. I can’t speak to the fundamentals, which may or may not have changed, but I do know this: once the fever breaks on a story that is so beloved, sentiment usually doesn’t stop deteriorating until the pendulum has overshot to the other side. And I get no sense we are near that point yet. I still see virtually all knife-catchers and no momentum shortsellers, and until this changes, it is probably not safe to buy the fruit.

Oh, and by the way, if the stock continues to go down, even if there aren’t good reasons for it, convincing-sounding reasons will be found. In the near-to-medium term story follows price more than price follows story more often than we are inclined to think.

Simple technical analysis suggests AAPL could go back to the area it broke out from in January, when the AAPL fever really took hold. That would correspond to price of about 425.

Finally, the other beloved sector that has just begun the beat-down process is the mortgage REITs. High dividends are a drug once you get used to them, and retail investors and high net worth individuals are in deep. With double-digit dividends it is easy to get lulled into believing that they will paper over any capital losses. However, the combination of reinvestment risk and a highly levered product means the cutting of dividends that we have just begun to see have a long way to go. And retail never leaves gracefully. (The closed-end muni funds will, I fear, have their reinvestment comeuppance pretty soon as well. The math there is brutal.)

The bottom line is that it makes sense to be balanced here, with a constructive bias. This is not the fat pitch for a directional view. But it does make sense to bet on balance sheet reparation, financial normalization, and continued recovery in the US, and against crowded story trades where the story may already have changed—no matter how much we may love them.