Tag Archives: quantitative easing

All Set for the Stock Market Top

John Mauldin recently wrapped up his annual Strategic Investment Conference and shared some insights from his illustrious speakers. In his world, the information he passed on in his summary was simply nuggets. In my world, I had to go digging for context to put it all together. As a trader, I live in a day-by-day world. As such, it’s easy to lose track of the big picture and at times, the proper context from which to view the macroeconomic landscape. Reading the notes from Mauldin’s speakers clearly illustrated two main points for my own trading.

Continue reading All Set for the Stock Market Top

The Fed is Cornering Itself

The government shutdown has passed and the markets are still here. The stopgap measures that kicked the can into early next year merely provided a buying opportunity in the interest rate sector for the top 1% while providing the catalyst for the final leg up in a bubble that makes the housing issue of ’07 look like an appetizer. Recent reports suggest that two separate papers presented at the International Monetary Fund meeting this week highlight the potential for a serious revision and extension of the fiscal stimulus plans already in place. Given the current nature of our markets, it’s hard to see how this doesn’t turn sour in the long run.

The Federal Reserve Board has two primary objectives; fostering full employment and stabilizing market prices. Historically, market prices referred to those things in life, which affect all of us like, milk, gasoline and farmland. This perspective has increasingly shifted towards the stabilization of more esoteric prices like the stock markets and interest rates. This shift in focus was originally designed to prop up a swooning stock market as well as getting capital flowing again during the heart of the economic collapse of ’08. The markets came roaring back with equities more than doubling and reaching all time highs this year and interest rates have bumped along at historic lows ever since.

The Fed achieved their goal of stabilizing prices ages ago and it has been proven that each additional increase in Quantitative Easing has been exponentially less effective than the previous one. This path will be followed for the next four years as Janet Yellen is handed the reins of the Fed next year. Why would the smartest minds ignore the data that so clearly illustrates these points? The simple answer is that, “and in other news, the Dow Jones Industrial Average reached another new high today,” sounds like a win to the average John Doe. The truth is that the average John Doe has never participated less in a stock market rally. Furthermore, the headline unemployment rate of 7.2% does not take into account that the labor participation rate is at a 35 year low. Therefore, the unemployment rate as published fails to include 90 million Americans who’ve simply given up looking for work and are drawing no unemployment assistance, thus no longer counting as unemployed.

Recent talk of tapering off the $85 billion per month Fed bond buying programs spooked the equity markets and sent the bond market plummeting, and rightly so. There’s no question that the excess capital created by the Fed must end up somewhere. We’ve seen a full rotation out of stocks and interest rates and into commodities and gold. Now, it’s out of commodities and back into interest rates and equities. The government shutdown created the mother of all buying opportunities in the interest rate sector. You can see the commercial trader buying surge as the Fed’s suggestion in May scared the market. I believe this could lead to the final phase of an interest rate bubble that dwarfs the housing bubble because the big money knows the Fed is too scared to take their foot off of the accelerator and has backed themselves into a corner due to their willingness to manipulate prices on the open market.

We’ve already seen some of the smartest bond money in the world step aside with Bill Gross of Pimco choosing to exit the 30-year bond bull. However, like most smart money, he’s probably early on the way out and will probably miss the last leg up. Although, he was recently quoted about buying the bottom of the shutdown that it was like, “picking up pennies on the street. Somehow, I think he’ll survive. His pennies are not the same as my copper pennies. Banking analyst Dick Bove said on CNBC that the US balance sheet shows us at $16 TRILLION in the hole. Most of this is coming due between 2018 and 2020 as the Fed has taken advantage of lower yields across the board to increase the average length of maturity from 4.1 to 5.4 years since 2009.

Finally, the two papers presented this week will suggest that we EXTEND the length of the QE programs from the original goal of 6.5% unemployment and 2.5% inflation to perhaps 6% or even 5.5% unemployment as inflation is yet to rear its head. The Fed has increased its monetary base from less than $1 trillion prior to the economic implosion to more than $3.6 trillion. If the economic stimulus is the cause of the decline in unemployment from 10% to 7.2%, not counting a quarter of the US population who’ve quit looking for work, then a linear equation suggests that another $1 trillion would get us to 6% unemployment.

Current bond market expectations suggest the 10-year Treasury Note may close the year near 2.25%. That’s approximately 60 basis points above our current price of 126^27. The market would have to reach a new all time high of 133^13 for yields to decline this far. This represents a $6,500 rally per contract in the 10-year Note futures. Given the nature of the bond market, I expect to be able to get this market bought around the 125^00 level and would risk the trade to the 16-day government shutdown low around 122^00. This would provide a risk to reward of $3,000 to $8,400. While we fully intend to trade the bond rally, our primary concern remains focused on what happens once it’s over. The big question remains, “How can the Fed weasel its way out of a situation that they created for themselves while continuing to suggest not only its continuation but, its continuation beyond the original scope of its design?”

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Tidal Shift in the Bond Market

The recent spike in Treasury yields could very well be signaling a change in trend direction. We rarely try to pick tops or bottoms in major trending markets. It simply doesn’t pay. However, we’re seeing lots of corroborating evidence that this may signal a shift in the global macroeconomic outlook. Therefore, this is one of the rare times when a pull back within the interest rate sector may not be a buying opportunity. In fact, if this is the beginning of the Great Unwinding we need to focus on all of the evidence to obtain a complete picture view, all the way from the trading screens to the man on the street.

The trading screens always provide the first clues of market direction. It’s important to remember that prices and yields trade inversely to each other. Therefore, when the price of the security rises, the interest rate declines. The opposite is also true. This is why we can talk about all time high prices and record low yields in the same sentence. The 10-year Treasury Note is the global proxy for US interest rates.

The last leg of this rally began in late November of 2007. The employment situation was starting to deteriorate and interest rate adjustment was the primary tool the Federal Reserve used to pump life into a faltering economy – prior to the economic collapse. The Fed lowered rates by a quarter point in four out of the last five months of 2007. They lowered rates eight more times in 2008 and finally committed to a zero rate policy in February of 2010.

The combined inventive efforts at the Fed eventually drove the 10-year rate to an all time low just under 1.5% in the cash market and an all time low on the 10-year futures of 2.3%. This is where it starts to get interesting. The 10-year Note has been trading at a negative real return for over a year. This means the interest generated by the instrument’s yield would not keep pace with inflation’s erosion of principle. The recent sell off has pushed its nominal yield above 2% while inflation is expected to remain a hair under that mark. Thus, bringing our first, “normal” look at a yield curve in ages.

The high water mark set in early May was fueled in part by Japan’s concerted depreciation of the Yen. The markets were well prepared for this. The US has provided massive stimulus over the last five years. Europe has added their share over the last three years through Greece, Spain and now, Cyprus. The logical next step in a globally competitive devaluation race was obviously a form of Quantitative Easing by Japan. Commercial traders here in the US stocked up on 10year Notes, accumulating their largest long position since February of 2008. Their expectation was that we would continue pushing the zero bound interest rate plan.

This may very well be one of the rare times when the commercial traders are just plain wrong. Historically, they’ve been very good at forecasting rate direction. This time the largest trading group may have been faked out as a whole. Two important points bring this home. First of all, their buying did fuel a rally to new highs…by a hair. Secondly, the weekly chart is beginning to show an obvious reversal bar. Will this turn into an, “Everybody out of the pool,” moment? I doubt it. However, I do expect them to continue to offload recent purchases, which will build up resistance on any attempted rallies.

The other primary point to make is the effect of the rise in interest rates on the housing market and its effect on the anemic economic recovery 99% of us have participated in. The national average 30-year mortgage has climbed by nearly 25% over the last few weeks rising from 3.4% to 4.2% according to Bankrate.com. This will have a big impact on the housing market, which had just begun to clear some inventory. This will also affect mortgage refinancing just as the deadline for governmental forgiveness approaches. The result of the spike in interest rates has caused a decline in the broad S&P 500 of nearly 4%. Meanwhile, the homebuilders ETF (XHB) has declined by almost 10%. The homebuilders have been a primary driver of the broad market’s rally since 2012 gaining nearly 100% in two years.

Higher interest rates are the last thing any of the major economies can afford. Half a decade’s worth of rate cuts, Quantitative Easing and Operation Twist, etc. have created a coiled spring of leveraged money hunting for that last bit of yield. The major reversal bar in the 10-year futures coupled with a large, unprofitable, commercial trader’s position could leave them left holding the hot potato. At its worst, this spike in rates steers us towards stagflation. An environment with rising inflation and no growth characterizes this. How far it spills over into the markets is unsure. Please call with any questions as this may well mark the inflexion point of what has been THE dominant trend over the last five years.

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.

Jumpstarting the Japanese Economy

The Japanese economy has languished in a deflationary environment for years. The recent Parliamentary elections have ushered in the potential for major shifts in policy, both ideologically and practically speaking. The election of Shinzo Abe as the new Prime Minister and overwhelming support for his Liberal Democratic Party will allow the new regime to control both the upper and lower houses. Therefore, no bargains or watered down policy will need to be struck. The sweeping results are a clear statement by the Japanese people that they expect action to be taken to loosen the money supply, inflate the economy and devalue the Yen.

Japan’s economy is roughly 1/4th the size of ours and places them as the fourth largest economy in the world. Therefore, full-scale policy shifts are rare and require a good bit of fortunate timing to implement. There are enough pieces in place to see more unilateral action by Japan as Mr. Abe focuses on the immediate needs of his people rather than finding the right political fit for Japan within the global political dynamic.

Deflation has been the key to the Japanese economy since the late nineties. Over the last 13 years they’ve recorded two inflationary years – 2006 and 2008. Mr. Abe wants to target new inflation and growth targets of 2% and 3%, respectively. Japan hasn’t recorded inflation above 2% annually since 1991. He expects to reach these goals through pressuring the Bank of Japan to loosen lending requirements and purchasing construction bonds for public works projects as their own method of Quantitative Easing. He also expects to include the first steps of domestic military spending to assert their claim to islands in the South China Sea as well as domestic pork barrel subsidies and governmental contracts to boost domestic GDP and help bring them out of recession.

However, considering that Japan already has one of the highest debt to GDP ratios in the world, ranking only behind Zimbabwe, Mr. Abe’s intentions are being watched closely by the credit agencies who already have Japan in a negative watch position and susceptible to further outright credit downgrades. Currently, Moody’s and Standard & Poors rate Japanese debt as equally trustworthy as countries like Chile, Macau and Bermuda. These are drops in the bucket compared to the weight the Japanese economy brings to bear on world trade. Fitch is the only rating company still holding Japanese credit at A+.

Inflating the economy by selling government treasuries is also designed to devalue the Yen against the major world currencies and help fuel their export dependent economy. The Yen has strengthened considerably over the last few years trading from a low of 115 Yen to the U.S. Dollar in July of 2007 to as high as 75 Yen per Dollar this time last year. Currently, the Yen is trading around 84 Yen to the Dollar. Japan is the second largest holder of U.S. Dollar reserves behind only China. Therefore, it could require a tidal wave of selling to make a dent in their $1.25 trillion in U.S. Dollar reserves.

The trading scenario is the mirror image of, “Don’t fight the Fed.” Japan has the financial power Mr. Abe has the political power and the support of the Japanese people. This should manifest itself as cheaper Yen and higher yields on the Japanese Government Bonds. Therefore, I expect the 75 Yen per dollar high set last year to hold and would like to sell Yen at 80. Note that these quotes have been provided in the number of Yen per Dollar while CNBC and U.S. futures quotes will show the inverse, which is what percentage of a Dollar will one Yen buy. Currently, one Yen will buy .00186 worth of a Dollar. Be careful to compare apples to apples when checking market prices.

The next big piece of this puzzle will be the inflationary effect on Japanese Government Bonds (JGB’s). The previous yield high was made in 2007 along with the bottom in the currency. The JGB reaction to the election announcement was swift. The futures have put in a full bearish reversal bar on the monthly chart. This is the first one we’ve seen in this market since June of 2003. Adding to the power of the reversal is the double top formed with the current high nearly matching the June ’03 high to the tick. Looking for places to sell Japanese Treasuries and currency as part of a long-term trade would be well advised as the timing and opportunity for real political and monetary change happens far less than the politicians would have us believe.

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.

Cutting Through the Rhetoric

There are times when the markets tell us more about what’s going on than the people on TV. I think this is one of those times. The recent rhetoric has been a political budget argument over nickels and dimes when we they need to be talking about hundreds and thousands. The political blame and spin game is being played at its highest level. The reality is that we are quickly approaching the end of the second round of quantitative easing. The government’s balance sheet reached a record level of $2.63 trillion as of April 7th. This is evidence that the fed has been putting their purchasing power to work. The $600 billion that was enacted to keep interest rates low, provide loans to new businesses and help the economy regain its footing after the financial meltdown of ’08 may be coming to an early end. The markets suggest that the Fed’s next meeting on April 26th could put a kink in the free flow of dollars coming to the market.

There are arguments on both sides of this fence from the insignificant periphery right down to the board of governors itself. The quantifiable portion of this argument is that the commercial traders clearly expect a slowdown in inflation and the economy in the near term. The consensus and conviction of the commercial traders’ positions can be seen in multiple markets; corn, oil, heating oil, copper, bonds, 10 year notes, S&P 500 and Dow Jones futures, etc. Their shift in positions can best be described as, “defensive.”

Copper is typically referred to as the, “economist” of the metals markets. Its use in building construction has always been a fair barometer of the economy’s growth and contraction. Commercial traders in copper from the commitment of traders report have shed nearly 40% of their positions since late February. The combination of China’s successive rate hikes and tightening lending practices paint a clear picture that their fully stocked warehouses are in no danger of depletion.

The crude oil market has seen consistent selling by commercial traders above $100 per barrel. Fear, due to the unrest in Northern Africa has been the primary driver of crude oil prices. This market has remained oblivious to the fact that the storage wells in Cushing, Oklahoma are bumping along near record levels. The price of gasoline has disconnected from the price of crude due to refining issues, not supply issues.

Interest rate futures have seen a flush of commercial buying. The 10 year Treasury Notes have seen commercial positions increase by more than 20% while the 30 year bonds have seen commercial traders increase their net position from 70, 000 contracts at the end of February to more than 120,000 contracts currently. Their buying of U.S. interest rate futures is part technical, and part predictive of a flight to safety driving down Treasury yields.

The flight to safety is predicted from commercial traders selling stock index futures. Commercial traders were buyers on the mid March stock market correction. However, their buying was light and their selling since has pushed their net momentum to negative levels. They may view the extended period of low volatility in the VIX index combined with testing the markets’ February highs as reasonable long liquidation levels or, low risk short selling opportunities.

This combination of moves is certainly bearish. I believe it is predicated by the theory that QE2 may be brought to an early end. If this is the case, the short term reaction would be a stronger U.S. Dollar. This would obviously be a short term negative for commodity markets in general like copper, oil, grains, cotton, etc. However, this would do nothing to alter the global change in demographics. There will be no fewer people to feed and this will not impact the growing global purchasing power that has fueled much of the commodity rally. Therefore, the macro trends will remain intact. This will simply force out many of the weaker hands that have been riding the coat tails of the rallies on the way up.

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.

Ending on a High Note

The market has stated repeatedly throughout 2010 that it’s good to own, “stuff.” Tangible assets with a finite supply have increased in value because they are known quantities. The United States and the European Union are devaluing their currencies through various forms of Quantitative easing and investors face growing concern that fiat currencies lack real meaning. The combination of low interest rates and limited supply has pushed the commodity markets to the front of the attractive investment sectors in 2010 and should continue to shine in 2011 as the U.S. economy falters under the weight of its own debt while reinventing itself as a global service provider rather than global manufacturer.

 

The commodity markets posted new investment interest highs in 18 markets in 2010. This means that almost half of all mature domestic commodity markets reported all time highs in outside investor interest. These markets not only include the headline leaders like gold, silver and oil but also cotton, which has doubled since August. Furthermore, investors are using the commodity markets to hedge their own portfolios in the face of uncertainty in the cash markets. Three commodity markets reached all time highs in investor interest on the short side. The S&P 500, 10 year Treasury Note and the Euro currency all set new records in 2010 for net investor short interest. These markets were sold in record numbers in anticipation of stock market declines in February, an expected rise in Treasury yields in April and a weakening of the Euro currency in May.

 

The stock and bond markets are unlikely to lure money away from the commodity markets in 2011. I think it’s very likely that we’ll see our economy slip back into recession by the third quarter of 2011 with unemployment climbing above 10.5% and moving past 11%. Generally speaking, the economy needs to create more than 100,000 jobs per month to hold the unemployment rate steady from the previous month. Eight million jobs have been lost since the recession began in December of 2007. Those jobs have not been replaced since the National Bureau of Economic Research signaled the end of the recession this past June. In fact, Princeton economist Paul Krugman states that the economy needs to create 250,000 jobs per month, every month, for the next five years just to get back to where we were before it all hit the fan in ’07. Finally, small business creation and growth is what drives the employment picture and the National Federation of Independent Businesses monthly surveys simply do not support a robust recovery picture.

 

This general picture is further supported by the most recent commitment of traders data commercial trader momentum in the S&P 500 turned negative to join the Dow and Nasdaq, which had already turned. Negative momentum across all three major indexes has been a reliable forecaster of topping action in the stock markets including the recent tops in April. When we combine this with the strong buying action across the short to mid term treasuries this past week, it’s clear that professional money is moving to safer bets to start the new year.

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.