Welcome To Zugzwang

 

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Between the PBoC spending reserves defending it’s currency, sovereign wealth funds liquidating assets to pay expenses, and the Fed tightening as the economy slows down, the world is undergoing a massive liquidity drain. The carry trades that levered up the world are being unwound which is causing volatility in the equity and more importantly the currency markets.

The three most imbalanced carry trades are dollar-EM, euro-dollar, and yen-dollar. When these carry trades unwind, liquidity is pulled from one market to the other.

As we’ve seen in this US stock market sell off, the Yen has strengthened against the dollar. This is a direct effect of Yen-dollar carry trade unwinding. The same effect has been observed in the Euro. The stronger currencies in a deflationary world crush their respective economies and all of this is occurring in spite of both economies undergoing a massive quantitative easing program!

Normally this is the part here Scooby utters “Ruh-oh, Shaggy!” but it gets worse!

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Because we live in a relative world, and if the ECB and BoJ unleash further easing on the world, then they will strengthen the dollar.

A strong dollar, as I’ve explained ad nauseam but will do again because it is so essential to this narrative, drains liquidity from the global economy through a NUMBER of mechanisms.

  1. A stronger dollar causes the US to import more deflation, slowing our economy and our demand down, thus leading to a smaller export of dollars to foreign markets that need these dollars most. It also forces the unwind in the largest trade in history, the $9trillion in foreign dollar borrowing. This strengthens the dollar even more and squeezes dollar funding out of emerging markets. So EM nations sell off, further weakening their economy. EMs now make up 50% of the world economy so a slowdown in EMs slows the developed markets around the world.
  2. Specifically China is incredibly vulnerable to the already strong dollar. Most of the Chinese people hold their capital in the country. Yes the ultra rich have been bringing capital out of the country for years now, but it pales in comparison to the current flight. Any hope of capital flows reversing have quickly died with the Chinese Government’s poor handling of their economy’s “transition”. Confidence in the Party and Xi’s ability to manage the massive credit bubble has been brought into question. The capital controls, they’ve put in place only further deter capital from flowing into the Chinese economy. To make matters even worse, they have wasted over a trillion dollars in precious liquidity defending their indefensible currency peg. To put this in perspective, if we look at capital flight, the dollar’s current level is more harmful to China than $30 oil is to Saudi Arabia. 
  3. With global demand, and Emerging market growth on the decline, the fragile economies of developed markets start to keel over. Which is what we are seeing in Europe, Canada, Australia, and even the United States. Most major equity markets are down 20% from their peaks. This in effect has taken trillions of dollars out of the system.
  4. Sovereign wealth funds that depend on high asset prices to bolster their economies in times of need are essentially burning the candle at both ends. The value of the individual assets are declining at the same time their oil revenues are.

Thus as we can see, the dollar at its current level is very harmful to the global economy and any further strengthening would accelerate the global liquidity drain. Like I said in the beginning, the liquidity drain is unwinding carry trades which strengthens the Yen and the Euro! Now this is the part where Shaggy goes Zoinks!

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In short, any Yen and Euro devaluation is incredibly short lived as the stronger dollar ends up strengthening the Yen and Euro in the end!

Meanwhile, as these three dance around like idiots over a hot bed of coals, China is hovering above with the sword of Damocles about to strike. China’s devaluation is a ticking time bomb for the world. And with an estimated $180B capital outflows in January, China has until June before starts to dip into it’s precious silk road fund.

Which brings me to the title of today’s post.

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The ECB, BoJ, and the PBoC cannot move without destabilizing the global economy even further. At the same time,  their respective economies are deteriorating in front of their noses. Other people will say, that they are “out of bullets”. Whatever your expression is, the BoJ and the ECB and for that matter the PBoC are all stuck in Zugzwang. This is why the BoJ went negative rather than printing more money. It was a small but meaningful gesture that the BoJ is acknowledging the Yen’s recent strength cannot be tolerated. But they can’t really do much more than that at this point. Any increased strength in the dollar will come back to hit them in the face with a global sell off and the unwinding of carry trades.

The implications for central banker Zugzwang cannot be understated at this time. Without effective tools at combating deflation and market instability, the world headed into another crisis this time without a wheel to steer the ship. It’s important to remember that most of the world leaders who have charted the course of the world economy since the last crisis are still in power. Which leads me to believe that the world is in for a massive amount of regime change. Safety is the name of the game here. Buy it before it becomes to expensive to do so.

 

Fed Speak: Long Term Hedge With MLPs

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The Fed speaks at 2:00PM EST today. The importance of their diction cannot be understated. Burst commodity bubble has the markets spooked.

In today’s world perception is more important than reality. And right now, the world perceives the Fed’s rate hike cycle as a giant misstep.

If the Fed doesn’t come with a dovish touch today we’ll see an even bigger sell off in the markets as commodities drop on the dollar’s strength forcing more capital out of emerging markets.

The Fed is ignoring a very serious issue with the crash in commodities. We are witnessing a giant transfer of wealth from commodity producer economies to consumer economies. Unfortunately trillions of dollars of funding was based on the exact opposite model.

One of the most important things about QE is that it loses its effectiveness over time. And considering how far commodity prices have fallen, even a 50% rally from these levels wouldn’t be enough to stem the destruction.

Any QE from the Fed at this point would have to be massive in scale and happen as soon as possible just to prevent commodity prices from falling even further.

Considering these are the same idiots who thought it was a good idea to start a rate hike cycle when there was $9 trillion dollar carry trade, falling commodity prices, low inflation, massive capital outflows from dollar pegged nations and a slowing US economy, I find it hard to believe that they will be quick enough to respond to the incredible threats they failed to understand in the first place.

In the short term, I expect the market to bowl over the Fed Speak as it rushes for the exits.

However, I can be wrong, and as this decision does come down to predicting what irrational people will do, it is important not to put all my eggs in one basket.

Which is why, I think an oil reflation trade, although short term is a terrible idea, long term looks quite promising.

By the end of the year, the Fed will most likely be back to easing, and oil will have probably made its bottom. This means that interest rates will fall, in a rising oil environment which is very good for MLPs, who benefit from both the interest rate differential and high price of oil which would allow more US production to stay or come back. Over the next few weeks I am looking to add the beginning of my MLP position.

There is still quite a lot of damage to be done to these guys. A lot of them built up a lot of debt while they were building their infrastructure, and with oil production in the US on decline, their revenues will decline. Throw in a tighter credit market with higher interest rates and MLPs will find it incredibly difficult to finance their debt. In the end, some of the MLPs will die, but the strong balance sheet companies that can take advantage of cheap asset prices will position themselves for years of growth to come.

 

2016 Yuan = 2008 US Housing

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I think the Yuan devaluation will be on similar in global financial destruction to what the US housing bubble did.

From companies, to investors, to governments, the world is more invested in the current central banking facade than it realizes and China’s devaluation threatens to undo it.

Don’t take my word for it. Just look around the world.

Europe is on the verge of another sovereign debt crisis, with the migrant crisis thrown in. And this is in the face of the massive QE program that I said almost a year ago to the day would fail and it has. The euro hasn’t fallen enough, and equities have crashed while credit risk has surged!

Japan is still Japaning all over the place, stuck in its deflationary trap.

Brazil is undergoing a sovereign debt crisis.

Canada and Australia with the most indebted private sectors in the globe are about to feel the double edged sword that is Chinese Overcapacity.

The United States by the end of the year, will probably grow at less than 1.5%. With US companies borrowing trillions of dollars to buy back their own stock, any significant drawdown will make these positive investments turn into heavy burdens.

Global commodity producers are struggling as multi-decade lows in commodity prices have rendered every investment they’ve made over the past decade uneconomical.

The Middle East is bloated with crashing economies clashing with each other.

The fact remains, that the world is a lot more volatile and fragile than central bankers would have you believe, and the next major shock will set it over the edge.

There is a slight difference from 2008 to now. Unlike 2008, QE has been established and some major banks are already actively involved in QE so I think the real difference between this crisis and 08 will be the speed at which central banks act, specifically the ECB and the BOJ.

I’m still a little worried about how quickly the Fed will react here and maybe we’ll get a better clue when Yellen speaks on Wednesday.

But the fact remains that a devaluation in the Yuan will send a shockwave through the $9trillion dollar global carry trade and there will be an absolutely enormous short squeeze on the dollar in emerging markets at the same time, asset prices in the world will engage in a huge sell off which will put further pressure on other carry trades in the Yen and Euro.

As they see their currencies rising, the ECB and the BOJ will also ease. Leaving the dollar the only game in town. Yellen will be forced to launch QE4 on a massive scale to devalue the dollar.

So the Chinese Yuan devaluation will reignite the global currency race to the bottom. Only this time, every nation’s currency will be thrown out of the windows with lead weights attached to them.

And then through all this, gold and silver finally break out of their slump and prepare for one of the largest gold bull markets in history.

In short, the global economy in 2016 is setting up for a giant liquidity crisis. At this point, I think it’s unavoidable. The Fed could come out on Wednesday and announce that it will double its balance sheet by the end of 2016 and that still wouldn’t save the Yuan.

China has committed to restructuring it’s economy. In order to do so, it believes it must impose stricter capital controls. If you can’t get your money out, then no one will want to bring their money in, which will deter flows from coming into China.

With all that said, I believe that China’s Yuan devaluation and the global liquidity crisis in 2016 is unavoidable. Once again I reiterate my fondness for US treasuries, gold, equity shorts, and cash.

 

Likelihood of QE4: Quite strong

Will the Fed launch QE4? It’s a simple question, a five word, seven syllable sentence. In my experience, the answer to this question depends on which camp you belong to. If you believe the US is in no danger of a recession, of course your answer is no and you look at the person asking the question with a tilted grin.

The problem is that there exists a very real probability of a US recession this year. If the Fed continues to tighten, a 2016 recession is all but guaranteed. At the very least the Fed has been forced to change its tune as China threatens to push the world into a global recession. China’s turmoil last august delayed the Fed rate hike by 3 months. So there is precedent of Chinese disruptions forcing looser monetary policy from this Fed. As China’s conditions deteriorate so to will the resource rich countries. With low oil prices on the verge of sparking financial crises in major oil producing countries around the world, it looks like QE4 is a matter of when not if. In short, the “fundamentals” supporting a future QE have arguably never been stronger.

However, there is that one small caveat, QE doesn’t work. With commodity prices at multi decade lows, QE has failed on an absolutely massive scale. The EU which is in the midst of its own failed QE program is going to hell in a handbag. EU equities are negative since the ECB launched its QE program a year ago. Now that’s not to say that QE doesn’t work in the short run but the diminishing returns have fallen so much that members of the FOMC are now forced to grapple with the idea that QE4 may not be worth it or if they do launch a QE program, the size of said program will have to be absolutely enormous to have any positive short term effect.

I think they will blink. I think that as the Fed stares down the bottomless asymmetric pit that is the global economy they will cave to pressure both internal and external. Imagine the public outrage at the Fed if they sat by and let the American economy collapse in on itself when everyone shares this belief that the Fed has the power to turn the economy around.

So if you are hoping that the Fed won’t allow your 401k to fall 20% before bouncing it back to all time highs you could be sadly mistaken. The Fed has been quite silent during this recent sell off which may show their frustration with the markets as well as their resistance to use looser policy.

I think some of this resistance lies in the belief that commodity prices can’t fall forever. And it’s true, they can’t go to zero, but as we have seen, they can go lower and can stay low for a very long time. Remember the Fed viewed oil’s drop as “transitory”. Of course everything that ever existed is transitory and this drop in oil is no different. The point is, the Fed has held this belief that commodity prices will eventually revert to their long term averages and rise which will put huge upward pressures on inflation. Starting from an incredibly low base, inflation could get out of control and the Fed would fall behind the curve. After all, “price stability” is the Fed’s most important objective.

But in a world where an inevitable Yuan devaluation leads to ABSOLUTELY MASSIVE SKULL CRUSHING AMOUNTS OF DEFLATION, the Fed will no longer be afraid of QE stoking a dramatic rebound in commodity prices. Without fears of higher inflation, the Fed will have the go ahead to launch QE4.

 

 

 

Slick Thoughts: A sharp spike down to trim the fat

I’m not lying when I say that I find the oil market incredibly fascinating. Many other commodities may be suffering as much if not more than oil, but oil is the global standard for energy and for the entire planet to have mispriced it as bad as we have is truly both amazing and terrifying.

In my last article I discussed my belief that something in the oil market will have to break. Whether it be land storage or high cost high debt producers. The price’s current trajectory and fundamentals  all indicate we still have further to go and this is excluding a number of increasingly likely external shocks ie. Yuan devaluation, US recession. If we assume the price falls even further into levels intolerable even by low cost producers, then there will be some very drastic outcomes.

Saudi Arabia is currently doing everything in its power to maintain the Riyal’s peg to the dollar. In my previous article, I argued that Saudi Arabia will do anything and absolutely everything before it is forced to break the Riyal’s peg to the dollar. Since that article, Saudi Arabia has offered to IPO their most prized possession, Aramco, and have now banned currency speculation. How viable are these solutions in the short run? Not very. It will probably take at least a year for the IPO to be launched at the very earliest and banning speculation does little against capital flight. Bets on the currency are much smaller than the flows which are the actual drivers of the currency market.

Notice how each attempt was even more desperate than the next. SA is desperate and with the price of oil headed lower, the Saudi’s will once again dip into their toolkit but find just one rusty, very blunt tool, an engineered market crash. Imagine what another month of oil in the 20s would do to SA’s economy. If oil to were remain at $30, SA would hemorrhage 1/3 of its FX reserves in a year. A large portion of those assets might not even be liquid. Thus the supply of liquid assets SA will burn through will be even greater, leaving the kingdom with even less ammunition to defend its peg.

SA may engineer a bottom in the market through drastic discounts to foreign markets. I’m talking high teens here to put the fear of Allah in the global energy market. The result would be a wave of bankruptcies and cuts in production and the price would rebound from there. It is a risky proposition to say the least, but so is openly pissing off a young uneducated and religious population through a currency devaluation. This is just one example of the extreme consequences of artificially low oil prices. There could be other lurking dangerous possibilities that haven’t been considered and the shocks unanticipated.

It’s important to note that, these oil producing nations don’t hold just a large pile of cash in their FX reserves. They own assets all over the world including equities in developed markets. And when the government needs to raise cash, they sell equities. Specifically US equities, after all they get dollars in return for oil not euros our pounds but dollars. As the price of oil falls, these funds need to sell off more of their liquid assets which draws down equity markets and further depreciates the valley of those assets. The guys at zerohedge have been talking about this since late early 2015. The fall in the price of oil has drained vast amounts of liquidity from the market, and we are starting to see those effects compound with the innate weaknesses and fragility of our dollar reserve currency system.

Sell equity markets. Treasuries still remain an amazing bet and I’m still amazed how many people believed the Fed would be successful in raising rates. That facade has almost faded and long dated US treasury yields should hit all time lows later this year.

Before I go, I want to reiterate my long term bullish stance on oil. The head of the IEA recently said the oil and gas market cut CapEx by a record amount in 2015 and in 2016 they are set to break that record with new cuts to CapEx. So the two biggest cuts in CapEx in the history of the oil and gas business have happened in back to back years. Once again we are setting up for another supply shock, but instead of a glut, there won’t be enough oil.

As of right now, oil futures for Dec 2017 are at $38. Just for a second imagine what the world would be like 2 years from now if oil was still trading in the 30’s. A hellish landscape of forgotten dreams and unimaginable nightmares! The point is, if you are wrong on this bet, then it doesn’t matter, because the world is ending! No but seriously, $38 oil for Dec 2017 sounds incredibly cheap and it may go even lower, but the amount of front loaded supply that’s come to market as a result of this drop in price will force oil prices higher before that December 2017, and those contracts are starting to look like a very nice buying opportunity.

Oil Market: Something Must Break

 

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Remember when the Fed said that “the decline in the price of oil was a net benefit to the American economy”. Funny how the market now takes that to mean every further drop in oil leads to a drop in the US stock market. Oil is on the market’s mind today and so to is it on mine.

The IEA released its state of the oil market so to speak, and it wasn’t pretty. With Iran exporting an extra 300,000 bpd of oil, supply could exceed demand by 1.5m bpd for the first half of this year.

Despite this massive oil glut, the IEA  still forecasts a decline of just 600,000 bpd in non-OPEC output. I find that unlikely given the downward pressure that 1.5m bpd oversupply in the oil market combined with slowing demand, and excess capacity would have on the price of oil. The price would continue to fall with those fundamentals.

With oil in the 20’s there isn’t much oil on earth that is profitable let alone in the United States and if the fundamentals are really as bad as the IEA is forecasting, we could see oil with a 1 handle by the middle of the year.

So at what point, do banks decide to withdraw credit lines from some of these oil and gas companies? Because I think it’s a lot sooner than the IEA and the EIA are both predicting. In the US alone, there is over $300B in debt on the books of oil and gas companies with negative cash flow.

Over the course of 5 years, that impressive rise in the chart above, the US added 5 million bpd and acquired billions of debt as companies perfected the techniques and technology. Historically, the amount of production they brought online in such a short time is quite impressive, but the debt they acquired during that time period will crush them. Not all of them, but at least 30%. Which translates into a 1.5 million barrel production drop from US shale alone. Not including bankruptcies  shale companies are being pushed to their limits at these prices. With even lower oil prices, the better balance sheet companies may forgo extraction in the short term as they wait for a rebound in prices. And the decline in capex will soon start to hit their future production. Thus the IEA’s 600,000 bpd production drop is way too low for 2016. There’s just no way, the current supply and demand mechanics allow for oil to stay in the 20s and 30s for the next 6 months without a serious amount of bankruptcies in US shale. Something will snap. Whether we see a quick drop in oil that causes a massive shake out in oil or we are already in said shake out, there needs to be a massive cut in oil production not just from the US but the rest of the world as well.

The point is, I think that the production is starting to turn, not just in the US but the rest of the world. The longer this process takes, the worse the imbalances will be in the future. In essence, the fall in oil price is frontloading supply, which is the exact opposite of the Fed’s ZIR and QE policies, which frontloaded the very demand that this supply is so pathetically searching for. If we look ahead a couple of years from when this supply was taken, we should expect a rise in the price of oil. The US oil and gas companies that survive the bust years will use their improved techniques and technology to extract oil more efficiently at these higher prices. So it’s not all build. Every selling opportunity becomes a buying opportunity at some point. And US shale will have it’s day again. The longer this imbalance goes on, the better it’s day will be.

 

The Next US Recession: Death By A Thousand Dominoes

It’s no secret that central bankers have flooded the world with cheap credit which has flowed into every asset known to man. The result was a massive inflation in asset prices, with the hope that real inflation would be close behind. When one looks at the commodity sector today, you wonder how any of these Central Bankers has a shred of credibility left. As the US economy runs headfirst into this immovable wall of deflation, economists and central bankers will watch helplessly as one by one sectors of the American economy fall like dominoes.

First there was oil. The US oil sector took a big hit. No big deal, the US is a net importer, we’ll benefit from the wealth transfer. But US oil sector was very capital intensive. They didn’t realize that they require lots of steel for pipes and drill bits and such. So the US steel sector took a hit. No big deal, we don’t really manufacture much anymore and we still import steel.

How do we transport oil in this country? By rail. How’s rail traffic going? It’s plummeted. Oh crap.

What about agriculture? The US is still the bread basket of the world. That has to be going well right? The Fed’s zero interest rate policies incentivized people to acquire debt to bid up the price of farmland. And now look, prices for farmland is at all time highs, but profits have fallen to a 13 year low with debt levels not seen in over 3 decades!

The sad thing is that the story of US agriculture and US shale are not unique. This story of cheap debt leading to short term asset and commodity inflation inevitably ends in a deflationary trap where these heavily indebted companies are forced to produce as much as possible in order to stave off bankruptcy.

The American economy is starting to feel the strain. Growth is slipping. Inflation is non-existent. At this point, everyone is just waiting for the next domino to fall. Will the auto sector be next or perhaps consumer spending? Either way, one thing is sure, enough dominoes have fallen that the momentum has been established. It’s only a matter of time before the rest of America takes a hit.