Tag Archives: ecb

Buying the ECB Rate Cut

The European Central Bank (ECB) is widely expected to cut their lending rates at the June 5th meeting. There are a couple of really interesting precedents setting up. First of all, the ECB is expected to
not only cut their discount rate but also the deposit rates paid to banks who park cash overnight at the ECB. Given the already low starting rate of .25% discount and 0% overnight, the expected cuts will cut the current discount rate in half and drive the overnight rate negative. Thus, the ECB will be charging banks to hold bank deposits. Secondly, the Euro currency market internals should be weakening ahead of the expected rate cut. After all, the rate cut should make owning Euros less attractive to the investing public’s hunt for yield. We’ll examine both of these situations as the former plays out on the
macro landscape while the latter presents an immediate trading opportunity.

Continue reading Buying the ECB Rate Cut

Global Uncertainty Strengthens Dollar

Five years ago the financial world was coming to an end. The stock market tanked and interest rates went negative due to the unsurpassed flight to safety in U.S. Treasuries. Most of this was due to greedy lending practices that claimed to be championing President Clinton’s thesis that everyone in America should be able to own a home. Lax lending requirements that were intended to get lower income earners into their own homes travelled up market and allowed upper middle and upper tier earners to refinance their houses at artificially low rates to buy second homes and Harley’s. Once again, misguided bureaucratic endeavors have been perverted by greed. The roaches in China are beginning to surface and the banking system stress tests in Europe are uncovering the depth of this five-year-old issue and once again, the primary beneficiary of these actions will be the U.S. Dollar.

Continue reading Global Uncertainty Strengthens Dollar

Cyprus Citizens vs. Russian Oligarchs

Cyprus has found its way into the epicenter of the European debt crisis by forcing their government to publicly choose whether they’re on the side of their citizens or whether they’ll side with billions of Rubles. It’s been several months since we’ve discussed the European debt crisis, which has now been brought to the fore by tiny little Cyprus. This little island in the Mediterranean is home to about 1.2 million people and sits on about 3,500 square miles. This makes its population smaller than Dallas and San Diego and slightly larger than San Jose or, Jacksonville while physically it fits between Rhode Island and Delaware.

Cyprus joined the European Union in 2004 amidst reports that Cyprus is primarily a money laundering country used mostly by Russians. Der Spiegel, a German newspaper, published a lengthy article in January based on an investigation by Germany’s Federal Intelligence Service regarding the degree of money laundering in Cyprus. The report found that more than $26 billion of the $80 billion that flowed out of Russia in 2011 ended up in Cypriot banks. The $26 billion that found its way into Cyprus is greater than their entire annual GDP.

The issue that Cyprus faces is that their role as a financial services hub has been severely hampered by the economic collapse of 2008. This has been made worse by the low tax rates and favorable corporate regulations that were used as incentives to attract capital in the first place. Therefore, Cyprus is stuck with the compounded slowdown of a declining economic base due to increased regulation along with a declining domestic tax base. The final blow to the Cypriot banking system is due to the failure of their banks’ investments in Greece.

The Cyprus government is now left with the unenviable task of finding a balance between its residents and the appeasement of its Russian investors. Current proposals suggest sharing the load between the Cypriot citizens and the Russian oligarchs. The European troika, (European Safety Mechanism, European Central Bank and the International Monetary Fund) wants Cyprus to come up with matching funds to bail them out.

The original proposal would have taxed bank accounts under $100,000 6.75% and accounts over $100,000 9.9%. The second proposal has several splits including removing the protection on deposits over $100,000 and taking the money from over funded accounts most likely held by Russian businesses. The downside, according to JP Morgan is that this would cost investors about 15% of their funds above $100,000. The third option is to split the costs of the failing banks by charging  3% on accounts less than $100,000, 10% on accounts between $100,000 – $500,000 and 15% on accounts above $500,000.

These are all logical solutions to an illogical problem that must be addressed by our societies as a whole. We’ve been discussing the flight of capital and capital will always flow towards the greatest possible potential. Cypriot corporate tax rates are half of the Russian rates and their capital gains taxes are even friendlier. The policies that have been put in place to attract capital come at the expense of those with no capital to spare. These morals are not tied to foreign capital and money laundering; they’re based on the collusion and graft of the people making the rules. Unfortunately, those of us with no voice will be expected to pay their share when things turn south.

Cyprus has seen its banks closed for days. There could be a run on the banks but I don’t think there will be. The billions of Rubles that flow through Cyprus will provide enough grease to absorb the bad debts on Grecian investments. Russia has no desire to see the back door closed. There will be a battle between transparency to the general public and the Great Oz who will do everything they can to ensure business as usual, regardless of the income source or destination of profits.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

The Value of the U.S. Dollar

The Federal Reserve Board is printing money at an unprecedented rate. The ECB is following suit. The Bank of England and China are both cutting rates to spur their economies and global sovereign debt is piling up like manure behind the elephant pen. Clearly, our currency is being devalued by the day. Some would argue that there’s a race to devalue among the major global currencies as the G7 nations attempt to boost exports and spur their respective domestic economies. Tangible assets like gold and silver or soybeans and crude oil may be the only true stores of value left in an increasingly wayward world. We read this every day. The truth is far less dramatic. In an ugly world, the U.S. Dollar is the prettiest of the ugly sisters at the ball.

The U.S. Dollar Index is exactly where it was four years ago. This is interesting considering that the aggregate money supply in the U.S. as a result of the quantitative easing programs has nearly doubled since the housing market collapsed. Theoretically, doubling the supply of U.S. Dollars should mean that each new dollar is worth half as much. Take this one step further and it’s logical to assume that if each new dollar is worth half as much then it should take twice as many dollars to make the same purchases that were made in 2008 yet, the Consumer Price Index is only 4.5% higher than it was then. Finally, I would suggest that considering the growth of the money supply and its characteristic devaluation, we should see an influx of foreign direct investment picking up U.S. assets at bargain basement prices. While logical, this is also incorrect as the U.S. Department of Commerce shows that foreign direct investment only exceeded U.S. investment abroad in 6 out of the last 20 years with 2005 as the most recent.

What has happened through the artificial manipulation of interest rates in the world’s largest market is that the U.S. Dollar has begun attracting large amounts of money as U.S. and global investors park their cash while waiting for clarification on the world’s major financial and political issues. Real interest rates in the U.S. are negative at least 10 years out. The Euro Zone is no closer to resolution. China is in the midst of changing leadership in a softening economy. Finally, what was an assured re-election of President Obama is now a legitimate race.

The inflows to the U.S. Dollar are easily tracked through the commercial trader positions published weekly by the Commodity Futures Trading Commission. The U.S. Dollar Index contract has a face value of $100,000 dollars. Commercial traders have purchased more than 25,000 contracts in the last few weeks, now parking an additional $25 billion dollars. The build in this position can also be seen in their selling of the Euro, Japanese Yen and Canadian Dollars. The Dollar Index is made up of these currencies by 57%, 13% and 9%, respectively. Collectively, commercial selling in these markets adds another $5 billion to their long U.S. Dollar total. The magnitude of these moves makes commercial traders the most bullish they’ve been on the U.S. Dollar since August of last year which immediately led to a 7.5% rally in the U.S. Dollar in September.

The degree of bullishness by the commercial traders in the U.S. Dollar forces us to examine the markets most closely related to it in order to monitor the spillover effect a rally in the Dollar might create. The stock market has traded opposite the Dollar for all but four weeks in the last two years. The last time these markets traded in the same direction on a monthly basis is August of 2008. The current correlation values of – .29 weekly and -.43 monthly suggest that for every 1% higher the Dollar moves, the S&P500 should fall by .29% and .43%, respectively. Therefore, a bullish Dollar outlook must be coupled with a bearish equity market forecast.

Finally, we see the same type of relationship building in the Treasury markets. The U.S. Dollar is positively correlated to the U.S. Treasury market. This makes all the sense in the world considering foreign holdings of U.S. debt have increased over 5% through the first seven months of 2012 (Fed’s most recent data). The bulk of these foreign purchases of U.S. debt are repatriated immediately to eliminate currency exchange risk. This process of sterilization forces interest rates and the Dollar to trade in roughly the same direction. This relationship turned briefly negative between April and June of this year on a weekly basis while one has to go back to March of 2010 to find a negative correlation at the monthly level.

Obviously, the trade here is to buy the U.S. Dollar. The negative speculative sentiment coupled with the bullish and growing position of the commercial traders could fuel a forceful rally. Small speculators typically accumulate their largest positions and are the most wrong at the major turning points. A recent study in the Wall Street Journal discussing individual traders’ biggest mistakes puts it succinctly. Small traders’ biggest mistakes, accounting for 60% of the total responses are being too late to get in and too cautious to take the next trade. Once burnt from exiting the last trade too late, the small investor is too scared jump in the next trade which reinforces the negative feedback loop they typically end up stuck in. Take advantage of this analysis and at least, prepare yourself with an alternate game plan.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

The Bernanke Put – Euro Style

The Spanish debt auction proceeded in an orderly fashion
even as yields crept higher. The general consensus appears to be that Spain is
too big to fail. I would suggest that Spain might be too big to save. Spain is
the European Union’s fourth largest economy and 14th largest in the
world. Last week, their credit rating was lowered to BBB+ by the Standard &
Poor’s rating agency. This week, they announced that their GDP had contracted
by 0.3%. This quarter’s decline marked the beginning of Spain’s second recession
since 2009. Finally, the composition of their debt makes any positive economic
headway in the next few years nearly impossible.

The interest rate benchmark is the 10-year bond or note.
Spain saw full participation at yields of 5.82%. There are two important points
to be made here. First, the participation rate is measured by the bid to cover
ratio. It was quite a bit stronger than the last auction in March, coming in at
2.9 compared to 2.4 for the last auction. The second point is the yield of
5.82%. The alarm bells sound when Spanish debt yields hit 6% on the 10-year
note. That’s the magic number at which Spain can no longer afford to refinance
or, rollover the financing of their budget. Spanish yields have solid
resistance between 6.125% and 6.25%. They peaked at 6.625% in November 2011.

The International Monetary fund released a report on the
European Union and the global debt issues entitled, “Global Financial Stability
Report.” Spain’s BBB+ credit rating is three notches above junk status. According
to the IMF the probability of default on BBB+ credit has risen from 0.734% in
2007 to 6.05% at the end of 2011. I believe that the recent pitches by the
BRIC’s (Brazil, Russia, India and China) to contribute to the bailout funds and
push the total available reserves to $430 billion has been received by the
markets as restoring confidence, rather than preparing for financial
Armageddon.

Spain’s primary source of trouble is the bursting of a
housing boom bubble. Sound familiar? Here in America we struggled through the
economic crisis as unemployment peaked at 10%. Meanwhile, the number of homes
in foreclosure peaked at 8.12 million in January of 2010 and drove home values
here down approximately 25%. Spain’s unemployment rate is nearly 25% and close
to 50% for people under 25. The Spanish real estate boom put 80% of the
population in home ownership. Foreclosure rates are now topping 10% at some
banks and the unemployment situation is creating a death spiral. This is
leading to marked to market values on repossessed homes as much as 60% below
their peak. Marked to market values leave the repossessing bank with an
over leveraged asset and reduces their capital base further constricting their
economy.

Spanish banks packaged their loans for resale on the
commercial credit market as mortgage backed securities. These securities were
prime at the time of origination. However, as their economy has declined the
nonperformance of these loans has placed more of them in the default category.
Some of these mortgage pools now contain up to 14% of mortgages more than 90
days over due. The obvious conclusion is that many Spanish banks are in
trouble.

The European Central Bank and the IMF have teamed up to try
and save Spain from themselves. The Troubled Asset Relief Program (TARP)
committed $470 billion to U.S. banks and the auto industry in order to keep
people in their homes and on the job. The $430 billion that has been pledged to
save Spain will not be enough to cover the mortgage losses. Furthermore, the
average Spaniard’s primary asset is their home, which accounts for
approximately 80% of their net worth. The Spanish debt will be hard to spread
around.

This leads to the IMF report on national household
deleveraging within the constructs of a banking crisis, which found that the
deleveraging process trims an average of 1.45% of GDP. European corporations
are already hurting. The lowest levels of corporate credit have skyrocketed
from 2% of total corporate credit to almost 16% of total corporate credit in
the last 5yrs. How will the ECB decide which ones are worth saving and how will
Spain feel about relinquishing their sovereignty to the decisions of the ECB
and the IMF? Government has never been very successful at manipulating markets
over the long haul. I believe the bond auction was palliative only because
investors are certain the ECB will backstop their purchases just as we have
grown accustomed to the Bernanke Put here in the U.S. Finally, when government’s
lose control of the markets they have been manipulating, the disaster is
spectacular.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Commercial Traders Wary of Risks Ahead

 

Commercial traders are building the case for their negative
outlook on the stock market. Their actions in several markets can be seen as
increasingly defensive over the last several weeks. Their behavior is also
beginning to be confirmed by several technical indicators, some of which are at
levels that haven’t been seen in nearly 15 years.

Last week we used the employment situation, profit margins
and earnings to suggest that it would be an historical event to start a new
bull market leg upwards from these levels and therefore, the short term pop on
the debt ceiling rally could be sold in the stock index futures market to
generate a short term profit. Deeper analysis reveals that selling stock index
futures at these levels may be an appropriate hedge for the longer term.

We all know that trading volume declines in the summer
months and the, “dog days of August.” Lower volumes and fewer market
participants leads to higher volatility. Monday morning’s sell off in the
S&P 500 was dramatic enough to make me sit up and take notice. The market
opened at 9:30 better than 1% higher thanks to the resolution of the debt
ceiling deal. The market then promptly sold off nearly 3% in a couple of hours.
The speed of its fall is what is noteworthy. A closer look shows that the
number of market participants as measured by open interest is the lowest it has
been since 1997. Open interest peaked in December of ’08 at more than 755,000
contracts. It is currently under 300,000.

Declining open interest becomes increasingly negative the
farther the market moves. Friday’s close marked the first week the S&P has
closed under its 40 week moving average since September of last year. A simple
timing model using the 40-week average and some interest rate calculations will
provide far superior risk adjusted returns simply by staying out of a weak
market that is trading below this level.

Moving to commercial trader analysis, we can see that they
have increasingly sold stock index futures since mid-June, in line with the
debt ceiling concerns. Their defensive trading behavior can also be seen in
their purchases of U.S. Treasuries. They have been solid buyers over the last
several weeks with a strong emphasis on short duration maturities like
Eurodollars and the 2 and 10 year Treasury Notes. The last part of the
inter-market puzzle is the strong move to U.S. cash reserves via the U.S.
Dollar Index. Commercial trader buying has increased by a startling 70% or,
more than 17,000 contracts in the last week.

Given the troubles coming to a budget agreement I looked
into why money was coming into the Dollar. The simple answer is that it’s a
value play relative to the Euro currency and the gold market. The recent
European Central Bank bailout of Greece is seen as a band-aid on a chain saw wound.
Two ECB questions remain, when will Greece default and will Italy and Spain be
next? The markets continue to question whether they will be able to continue
paying their debts and this can be seen in the record high interest rates they
are being forced to pay in the open market.

Finally, commercial traders see the typical safe haven of
gold as overvalued. Small traders and funds are holding a near record long
position in the gold market. The concern is that when the stock market fails
and cash needs to be raised, it can only come from positions that are
profitable. This would lead to profit taking in the gold market and drive it
lower. Since small traders and funds are typically quicker to react to major
market moves, the concern is that when the gold market falls, it could fall
quickly and deeply. This would wash out many of the small traders and put gold
back into play for the commercial hands waiting to buy the market again.

Bear Market Debt Ceiling Rally Should be Sold

Trading the stock markets has become, as much about guessing what the next news piece will be from the European Central Bank or the White House as it has market knowledge. News driven markets are notoriously tough to trade. This can be seen in lower trading volumes as market participants wait on the sidelines for things to sort themselves out and then rush in all at once when they think the market has given them an answer. Patience is the better part of valor. Successfully trading news event driven markets means having a sound strategy waiting to be put into action once the dust begins to clear. I think this is one of those times and this is the plan I’ll be implementing.

The debt ceiling and the Greek debt problems are hanging like a black cloud over the stock markets. Many believe that a resolution of these issues will lead to a reactionary stock market rally. I hope this is true because I’ll be selling stock index futures based on the assumption that a post debt ceiling resolution rally will be short lived and that the sell side of the market will be the proper side to trade from.

There are a few reasons for this. First of all, I believe that we have been in a secular bear market since the financial meltdown of ’08. Starting with that assumption, we have seen corporate profit margins soar since the market bottomed. However, most of this has been due to cost cutting of both labor and financing. As a result, corporate earnings are at their highest margin since their peak in ’06. This means that it is unrealistic to expect corporate profit margins to continue to rise.

Secondly, if we consider this a bear market rally, which I do, we have measurable statistics that say the stock market has NEVER rallied four straight years within the context of a secular bear market. We are in the third year of a rally, which already puts us into the 17% probability area. Furthermore, the average gain for consecutive up years in a bear market rally is 42%. The Dow is currently trading around 12,500. This is a cumulative gain of 43% from the ’09 close on a year over year basis. This puts us at the tail end of a bear market rally by historical measures.

Thirdly, we face structurally high unemployment here in the U.S. We need to average 115,000 new jobs every month just to maintain 9% unemployment. We averaged 78,000 per month throughout 2010. We are slightly ahead of pace in 2011 averaging 124,000. However, to lower the unemployment rate by 1%, we would need to average 240,000 per month for an entire year. The best decade ever for job growth was the technology driven 90’s when we averaged 181,000 per month for the decade.

Declining tax receipts based on lower corporate profits, lower employment numbers and disgruntled consumer sentiment combined with legislatively burdensome small business policies leaves little room for new hiring and small business growth. The last twelve months has seen the weakest small business growth in more than a decade.

Without another technological revolution or the mass renovation of our countries’ infrastructure, we will continue to fall behind developing nations.

These are the fundamental forces at work behind the constant news reports of who’s to blame for the last failed debt ceiling proposal and why I’ll be looking to sell the market. Therefore, when it is finally resolved, and I believe it will be. I expect the market to rally as a sigh of relief brings fresh money to the market like lambs to the wolf.

This blog is published by Andy
Waldock. Andy Waldock is a trader, analyst, broker and asset manager.
Therefore, Andy Waldock may have positions for himself, his family, or, his
clients in any market discussed. The blog is meant for educational purposes and
to develop a dialogue among those with an interest in the commodity markets.
The commodity markets employ a high degree of leverage and may not be suitable
for all investors. There is substantial risk of loss in investing in futures.

Reprofiling Greek Debt Boosts Gold and Dollar

Trading the markets is sometimes like being a relationship counselor. There are times when it’s easy to see how one thing done or said affects the other’s actions. We use a fancy term for it, correlational analysis. When the correlation is positive, both things move in the same direction and when it’s negative, they move in opposite directions. Pretty straightforward stuff like when the Dollar falls, gold climbs. That’s a negative correlation based on inflation. Similarly, the stock market rises as interest rates decline because businesses find cheaper money for expansion and capital equipment acquisition. Unfortunately, every good therapist knows that relationships change over time. These markets, in particular, are not performing true to pattern.

Fortunately, in the financial world, we have tools that let us quantify these relationships. Now, it’s true that over the last year, gold has rallied and the Dollar has fallen. However, over the last couple of weeks, both the Dollar and gold have rallied. I think there is a significant change in the underlying nature of their relationship that could cause this to continue throughout the summer.

The primary reason for the Dollar’s strength has not been the domestic economy. The strength should be attributed to the global fear of a collapsing Euro, which attracts money to the U.S. as a flight to safety. We’ve talked at length about the troubles in Ireland and Greece. Well, Spain and Portugal are right behind them. The global credit markets are already pricing in the pending defaults. Greek 10 year bonds are yielding north of 16% and Ireland and Portugal are both above 9%. This compares to the U.K. Gilt 10 year yield of 3.3% and the U.S. 10 year Note’s yield of 3.1%. The European Union is caught between balancing what the Union’s lenders will accept as payment versus what rights of autonomy the borrowers will relinquish to remain in the Union itself.

The new catch phrase is a, “reprofiling” of debt. This word isn’t even in Microsoft’s spell check. However, this invention by the European Central Bank is really a synonym for, “default.” They want to extend the maturity dates of Greek debt. The Euro has fallen 7% as we’ve hunted through Webster’s Dictionary for, “reprofile.” The reprofiling or, restructuring of Greek debt would seriously devalue the 50 – 80 billion the ECB has already contributed monetarily and devastate the value of the European Union’s political solidarity.

The same fear of a Euro collapse has attracted money to the gold market. This week, gold hit an all time high priced in Euros. Investors are looking for a safer holding facility for their liquid cash than the Euro currency can provide them with. This move has been extended as the ECB has chosen to cancel its June meeting while reprofiling studies are being completed for their newly scheduled July meeting. Consequently, there have been four trading days in the last ten where both gold and the Dollar have rallied more than half of a percent. This compares to six days in the last twelve months when this has happened.

The rise in the Dollar has also coincided with a flood of money into U.S. Treasuries and a decline in the U.S. stock market. Commercial traders are aggressively rotating their positions from stocks to bonds as the Euro Zone drama is playing out. This is taking the classic low yield/high growth stock market relationship and turning it into a low yield/no growth scenario more consistent with times of fear. We’ve seen commercial money buying 10yr Notes in six of the last seven weeks and selling in the stock indexes in each of the last four weeks.

Reconciling relationships means being able to cope with change and allowing the relationship’s participants to grow in their own directions. Being able to recognize these changes in the marketplace as they are happening requires a sound combination of reading the back-stories and quantifying the participants’ actions.

This blog is published by Andy
Waldock. Andy Waldock is a trader, analyst, broker and asset manager.
Therefore, Andy Waldock may have positions for himself, his family, or, his
clients in any market discussed. The blog is meant for educational purposes and
to develop a dialogue among those with an interest in the commodity markets.
The commodity markets employ a high degree of leverage and may not be suitable
for all investors. There is substantial risk of loss in investing in futures.

Commodities Still Strong Amid Global Uncertainty

The Eurozone debt concerns have finally taken their rightful place as a daily front -page news story. Tuesday, Spain brought 2.5 billion Euros to market in 12-month bonds. The average rate for the auction was 3.45%. This is 45% higher than previous month’s auction rate. For the sake of comparison, it’s hard to find a 12-month CD over 1% here. Wednesday, 20,000 Grecians rioted in response to the latest round of austerity cuts. Finally, European Central Bank President Jean -Claude Trichet is calling for an expanded role of the bailout fund. These headlines all echo the same theme…uncertainty.

 

Uncertainty is a bigger impediment to fully functioning markets than fear or, greed. Uncertainty prevents planning and prevents action. While Europe digests their own financial crisis, we can take a look at the effects of our own actions here as well as what to expect in the coming months.

 

Throughout the late summer and into fall, many leading analysts suggested that the domestic stock market was a much better investment than the domestic bond market. This includes people like Warren Buffet, James Paulson and Alan Greenspan. Their general assertion was that the effects of the loose monetary policy put in place to provide liquidity and jump- start the economy was holding interest rates at artificially low levels.  Therefore, the risk premium, which compares investing in stocks versus bonds, had swung in favor of equities. The fourth quarter has clearly proven this to be correct with the stock market up 9% so far in Q4 while the 30yr. Treasury bond has declined more than 9.5% in price.

 

Most of this rally has been based on the unwinding of the fear and carry trades. Investors must constantly balance yield versus safety. Lately, the investment world has become virtually unmanageable to the individual investor attempting to figure out what the global leaders will put into play, how it will affect their portfolio and finally, what actions can be taken to capitalize on that analysis if it is correct. For example, it was generally accepted that the domestic stock market, metals markets and the U.S. Dollar could not simultaneously trade in the same direction yet, that has been the case of the fourth quarter. In fact, a decline in commodity prices combined with a rise in borrowing costs would put a real squeeze on the carry trades that have been placed over the last two years.

 

One solution to this puzzle is to focus on individual pieces. Sometimes, we don’t have to know what the final picture looks like. Eventually, if we keep putting the pieces in the right places, the picture will take shape. Therefore, some of the assumptions we will be working with are:

–       The U.S. is ahead of Europe in dealing with the financial crisis.

–       The U.S is still the largest safe haven economy.

–       Euro weakness will make the Dollar seem strong by comparison.

–       Developing Tiger countries are the engines driving global growth.

These ideas will continue place us on the long side of the commodity markets, while trading both sides of the Stock market and the U.S. Dollar. The markets should become less predictable and volatility should increase as the risk premium between the currency, equity and commodity trades continues to tighten. This will place many asset classes on equal footing and leave alpha to be gained only through the careful examination of the individual issues within those asset classes.

 

Out of the 36 markets that we track on a daily basis, 25 of them are facing negative commercial trader momentum. As we discussed a couple of weeks ago, some of these markets are near all time speculative limits. In fact, crude oil just set a new record for speculative long positions this week. This means that professional money managers are putting money to work buying crude oil while the people who produce it are selling all they can. The ability to follow the money flowing through the individual commodities provides a degree of certainty. This allows us to take action, using bottom up, micro economic analysis while the people at the top are still trying to figure it out on a macro economic basis.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Reasons for U.S. Dollar’s Strength

        

This blog is published by Andy
Waldock. Andy Waldock is a trader, analyst, broker and asset manager.
Therefore, Andy Waldock may have positions for himself, his family, or, his
clients in any market discussed. The blog is meant for educational purposes and
to develop a dialogue among those with an interest in the commodity markets.
The commodity markets employ a high degree of leverage and may not be suitable
for all investors. There is substantial risk in investing in futures.

It has been noted that the U.S. Dollar makes a high or a low for the year in January approximately 2/3 of the time. Some prominent market mavens are attributing the Dollar’s strength to “strong cyclical forces at play” while others believe that the Dollar’s time as the currency of last resort is nigh. Both positions appear, to me, to be based on more on rhetoric and black magic than on sound fundamental analysis. Those of you who’ve asked me about the Dollar have gotten the same response from me since the commodity futures market’s bottom in December. I don’t understand the Dollar’s strength. I can advise on technical levels and pattern recognition but, I don’t have a fundamental thesis to frame my trading in this market at this time. The following article by John Mauldin of www.frontlinethoughts.com has provided me with a framework I can wrap my head around. I hope it helps you as much as it has myself.Andy.

The Risk in Europe

I mentioned last
week that European banks are at significant risk. I want to follow up on that
point, as it is very important. Eastern Europe has borrowed an estimated $1.7
trillion, primarily from Western European banks. And much of Eastern Europe is
already in a deep recession bordering on depression. A great deal of that $1.7
trillion is at risk, especially the portion that is in Swiss francs. It is a
story that could easily be as big as the US subprime problem.

In Poland, as an
example, 60% of mortgages are in Swiss francs. When times are good and
currencies are stable, it is nice to have a low-interest Swiss mortgage. And as
a requirement for joining the euro currency union, Poland has been required to
keep its currency stable against the euro. This gave borrowers comfort that they
could borrow at low interest in francs or euros, rather than at much higher
local rates.

But in an echo of
teaser-rate subprimes here in the US, there is a problem. Along came the
synchronized global recession and large Polish current-account trade deficits,
which were three times those of the US in terms of GDP, just to give us some
perspective. Of course, if you are not a reserve currency this is going to
bring some pressure to bear. And it did. The Polish zloty has basically dropped
in half compared to the Swiss franc. That means if you are a mortgage holder,
your house payment just doubled. That same story is repeated all over the
Baltics and Eastern Europe.

Austrian banks
have lent $289 billion (230 billion euros) to Eastern Europe. That is 70% of Austrian
GDP. Much of it is in Swiss francs they borrowed from Swiss banks. Even a 10%
impairment (highly optimistic) would bankrupt the Austrian financial system,
says the Austrian finance minister, Joseph Proll. In the US we speak of banks
that are too big to be allowed to fail. But the reality is that we could
nationalize them if we needed to do so. (And for the record, I favor
nationalization and swift privatization. We cannot afford a repeat of Japan’s
zombie banks.)

The problem is
that in Europe there are many banks that are simply too big to save. The size
of the banks in terms of the GDP of the country in which they are domiciled is
all out of proportion. For my American readers, it would be as if the bank
bailout package were in excess of $14 trillion (give or take a few trillion).
In essence, there are small countries which have very large banks (relatively
speaking) that have gone outside their own borders to make loans and have done
so at levels of leverage which are far in excess of the most leveraged US
banks. The ability of the “host” countries to nationalize their banks
is simply not there. They are going to have to have help from larger countries.
But as we will see below, that help is problematical.

Western European
banks have been very aggressive in lending to emerging market countries
worldwide. Almost 75% of an estimated $4.9 trillion of loans outstanding are to
countries that are in deep recessions. Plus, according to the IMF, they are 50%
more leveraged than US banks.

Today the euro
rallied back to $1.26 based upon statements from German authorities that were
interpreted as a potential willingness to help out non-German (in particular,
Austrian) banks.

However, this
more sobering note from Strategic Energy was sent to me by a reader. It nicely
sums up my concerns:

“It is East
Europe that is blowing up right now. Erik Berglof, EBRD’s chief economist, told
me the region may need €400bn in help to cover loans and prop up the credit
system. Europe’s governments are making matters worse. Some are pressuring
their banks to pull back, undercutting subsidiaries in East Europe. Athens has
ordered Greek banks to pull out of the Balkans.

“The sums
needed are beyond the limits of the IMF, which has already bailed out Hungary,
Ukraine, Latvia, Belarus, Iceland, and Pakistan — and Turkey next — and is
fast exhausting its own $200bn (€155bn) reserve. We are nearing the point where
the IMF may have to print money for the world, using arcane powers to issue
Special Drawing Rights. Its $16bn rescue of Ukraine has unravelled. The country
— facing a 12% contraction in GDP after the collapse of steel prices — is
hurtling towards default, leaving Unicredit, Raffeisen and ING in the lurch.
Pakistan wants another $7.6bn. Latvia’s central bank governor has declared his
economy “clinically dead” after it shrank 10.5% in the fourth
quarter. Protesters have smashed the treasury and stormed parliament.

“‘This is
much worse than the East Asia crisis in the 1990s,’ said Lars Christensen, at
Danske Bank. ‘There are accidents waiting to happen across the region, but the
EU institutions don’t have any framework for dealing with this. The day they
decide not to save one of these one countries will be the trigger for a massive
crisis with contagion spreading into the EU.’ Europe is already in deeper
trouble than the ECB or EU leaders ever expected. Germany contracted at an
annual rate of 8.4% in the fourth quarter. If Deutsche Bank is correct, the
economy will have shrunk by nearly 9% before the end of this year. This is the sort
of level that stokes popular revolt.

“The
implications are obvious. Berlin is not going to rescue Ireland, Spain, Greece
and Portugal as the collapse of their credit bubbles leads to rising defaults,
or rescue Italy by accepting plans for EU “union bonds” should the
debt markets take fright at the rocketing trajectory of Italy’s public debt
(hitting 112pc of GDP next year, just revised up from 101pc — big change), or
rescue Austria from its Habsburg adventurism. So we watch and wait as the lethal
brush fires move closer. If one spark jumps across the eurozone line, we will
have global systemic crisis within days. Are the firemen ready?”

While Rome Burns

I hope the writer
is wrong. But the ECB is dithering while Rome burns. (Or at least their banking
system is — Italy’s banks have large exposure to Eastern Europe through
Austrian subsidiaries.) They need to bring rates down and figure out how to
move into quantitative easing. Europe is at far greater risk than the US.

Great Britain and
Europe as a whole are down about 6% in GDP on an annualized basis. The Bank
Credit Analyst sent the next graph out to their public list, and I reproduce it
here. (www.bcaresearch.com)
In another longer report, they note that the UK, Ireland, Denmark, and
Switzerland have the greatest risk of widespread bank nationalization (outside
of Iceland). The full report is quite sobering. The countries on the bottom of
the list are also in danger of having their credit ratings downgraded.

Aggregate Sovereign Credit Risk

This has the
potential to be a real crisis, far worse than in the US. Without concerted
action on the part of the ECB and the European countries that are relatively
strong, much of Europe could fall further into what would feel like a
depression. There is a problem, though. Imagine being a politician in Germany,
for instance. Your GDP is down by 8% last quarter. Unemployment is rising.
Budgets are under pressure, as tax collections are down. And you are going to
be asked to vote in favor of bailing out (pick a small country)? What will the
voters who put you into office think?

We are going to
find out this year whether the European Union is like the Three Musketeers. Are
they “all for one and one for all?” or is it every country for
itself? My bet (or hope) is that it is the former. Dissolution at this point
would be devastating for all concerned, and for the world economy at large.
Many of us in the US don’t think much about Europe or the rest of the world,
but without a healthy Europe, much of our world trade would vanish.

However, getting
all the parties to agree on what to do will take some serious leadership, which
does not seem to be in evidence at this point. The US almost waited too long to
respond to our crisis, but we had the “luxury” of only needing to get
a few people to agree as to the nature of the problems (whether they were wrong
or right is beside the point). And we have a central bank that could act
decisively.

As I understand
the European agreement, that situation does not exist in Europe. For the ECB to
print money as the US and the UK (and much of the non-EU developed world) will
do, takes agreement from all the member countries, and right now it appears the
German and Dutch governments are resisting such an idea.

As I write this
(on a plane on my way to Orlando) German finance minister Peer Steinbruck has
said it would be intolerable to let fellow EMU members fall victim to the
global financial crisis. “We have a number of countries in the eurozone
that are clearly getting into trouble on their payments,” he said.
“Ireland is in a very difficult situation.

“The
euro-region treaties don’t foresee any help for insolvent states, but in
reality the others would have to rescue those running into difficulty.”

That is a hopeful
sign. Ireland is indeed in dire straits, and is particularly vulnerable as it
is going to have to spend a serious percentage of its GDP on bailing out its
banks.

It is not clear
how it will all play out. But there is real risk of Europe dragging the world
into a longer, darker night. Their banks not only have exposure to our US
foibles, much of which has already been written off, but now many banks will
have to contend with massive losses from emerging-market loans, which could be
even larger than the losses stemming from US problems. Plus, they are more
leveraged. (This was definitely a topic of “Conversation” this
morning when I chatted with Nouriel Roubini. See more below.)

The Euro Back to Parity? Really?

I wrote over six
years ago, when the euro was below $1, that I thought the euro would rise to
over $1.50 (it went even higher) and then back to parity in the middle of the
next decade. I thought the decline would be due to large European government
deficits brought about by pension and health care promises to retirees, and those
problems do still loom.

It may be that
the current problems will push the euro to parity much sooner, possibly this
year. While that will be nice if you want to vacation in Europe, it will have
serious side effects on international trade. It clearly makes European
exporters more competitive with the rest of the world, and especially the US.
It also means that goods coming from Asia will cost more in Europe, unless
Asian countries decide to devalue their currencies to maintain an ability to
sell into Europe, which of course will bring howls from the US about currency
manipulation. It is going to put pressure on governments to enact some form of
trade protectionism, which would be devastating to the world economy.

Large and swift currency
swings are inherently disruptive. We are seeing volatility in the currency
markets unlike anything I have witnessed. I hope we do not see a precipitous
fall in value of the euro. It will be good for no one. It is a strange world
indeed when the US is having such a deep series of problems, the Fed and
Treasury are talking about printing a few trillion here and a few trillion
there, and at the very same time we see the dollar AND gold rising in value.