A Wild Trade Appears: Central Banking Mistakes Are Super Effective

Oh look, the Fed is back again talking up a rate hike. Man did they come out swinging this past week. Once again they are forcing the market  price in a rate hike.

Has the US economy turned a corner? No. Have they hit their inflation target? No. Was Yen strength causing problems? Yes. Was the SPY above 2000? Yes. Do I think the Fed is going to hike in September? No, but the September rate hike’s life depends on a lagging indicator which could make for an interesting trade.

The August NFP jobs number is supposed to come in around 220,000 this Friday. I think that if the number is 180,000+ which seems likely, the market will price in a Fed rate hike much higher than the current 33% chance right now.

That means the dollar will get stronger and US equities should fall. I hesitate to say which direction treasuries would go because any Fed tightening would be bullish for the long end of the treasury curve. The Yen could also weaken initially which would boost the Nikkei.

At the same time, I do not believe the Fed will in the end hike interest rates. For a few reasons. One reason, China cannot handle a rate hike. The PBOC does not want to inject more liquidity into the banking system which would weaken the Yuan.

“A cut to lenders’ reserve requirements would add too much liquidity to the financial system and lead to yuan depreciation expectations, China’s central bank said late Friday.”

If the the Fed hikes interest rates, liquidity would be pulled out of the Chinese economy. The PBOC then would be forced to do what it does not want to do and inject more liquidity via a rate cut to the RRR.

Also, this Fed is incredibly political. There’s a clear favoritism towards Hilary. Donald Trump has publicly said he would replace Yellen if elected. The point is, the Fed will not hike interest rates and risk Trump getting elected… UNLESS Hilary is a virtual lock to win the nomination. Do I think Hillary will be a lock to win the Nomination come September 20th? No.

Recently members of the Fed have discussed the possibility of raising the inflation target as well. Meaning, the Fed is looking for excuses to not hike interest rates. They know the data that they target ie. Jobs, Inflation, GDP growth will tell the market they should hike, but they are constantly looking for reasons to stay put.

Time and time again Yellen has proven to be timid and I think the September meeting will be no different.I do not claim to know the excuse the Fed will come up with this time, but they will find something.

Once the Fed backs off the dollar will fall, the Yen will rise, and the Nikkei will go back into crash mode. If the Fed does hike the Nikkei will also go into crash mode. Either way I think after the market prices in a rate hike over the next two weeks, shorting the Nikkei and being long Yen will be a good trade.

In the end, the Fed’s desperate attempts to force the market to price in a September rate hike could lead to predictable volatility in various asset classes that should be trade-able.

 

 

 

The Bull Case Revisited

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In this day and age of record low interest rates and record high asset prices it is hard enough to find a human being who is both rational and intelligent, let alone one that likes Hollywood’s sequel and reboot craze. With that said, serialized story telling when done right is incredibly rewarding as it gives us as viewers a chance to go deeper and further into the psyche of the characters we love.

Where am I going with this you might ask?

In the investment world, no one is an expert on everything. You constantly rely on the opinion of “experts” to form an opinion on a wide range of topics from China’s economic policy to the physics of lithium ion batteries.

At first glance, the major concern anyone has with an expert is are they right? In a bull market, it’s easy to look smart. Just look at all those “experts” on CNBC. What I find more important than being right, is how an expert processes new information and incorporates that into his or her opinion.

It’s this vital step, that is most often overlooked, ignored all together and what brings me to writing this very post today.

I have decided to write a sequel to my massively popular and successful summer blockbuster “Bulls On A Tightrope“. In it, I analysed a possible scenario that could negatively impact my bearish portfolio. Given that I am net short US equities and long US treasuries both of which are near all time highs, I thought now would be a great time to revisit the Bull Case.

I believe that the world economy could stabilize if the following conditions are met:

  1. The Yen and Euro weaken against the dollar.
  2. The dollar weakens against commodities and EM currencies.
  3. Emerging markets rebound accelerates into sustainable growth.
  4. The US economy stabilizes on the back of a weaker dollar.
  5. China continues to delay any real adjustment.

1) The Yen and Euro weaken against the dollar.

It’s safe to say, neither have happened. Back on May 14th, when I wrote the article USDJPY was at 108, and EURUSD was at 1.13. As of writing the sequel, USDJPY is at 100.72 and EURUSD hovering around 1.125.

Both are interesting stories in their own right. The Euro is trading quite strong against the dollar. Is this due to dollar weakness or Euro strength? The equity on Europe’s banks trades like it needs a bailout. Yet the Euro currency does not. Is this because the market believes there will be a successful bail in without causing systemic problems?

Or is the dollar really that weak? A few years ago, the Fed loved to talk about “escape velocity”, like they were on par with the scientists and engineers that launched men and women into space. Remember that? I’m sure central bankers don’t want you to. US GDP growth for the first half of 2016 was a pathetic 1%.

The US economy is not stabilizing on the back of a weaker dollar. It’s slowing down. Now that doesn’t stop the Atlanta Fed to predict a ridiculous Q3 GDP growth rate of 3.6%.

But it seems to me that we are finally witnessing the market price in the reality that escape velocity was a fairy tale. As such, I expect the dollar to head down over the next month or two which should be positive for commodities, inflation and EM.

Any potential upside in this downward move in the dollar should be limited by the negative effects of a weaker dollar because the dollar is the quintessential tightrope that our policy makers are forced to walk. If the dollar weakens too much, Japan and Europe run into trouble. If it strengthens too much China throws a fit and sends the world some nasty deflationary pulses.

Of the three, only China has proven effective in weakening its own currency. This is where it gets interesting, because if Japan cannot weaken the Yen, the Fed may be forced to strengthen the dollar to counteract any Yen strength.

This is why Dudley talked up a September rate hike just hours after  USDJPY dipped below 100 on Monday. He bought some time, but not much. This isn’t 2012 anymore. Words are not enough to save the markets.

 

The possibility of a Fed rate hike going into a tumultuous US election with a slowing US economy is not something I want to be bullish on.

Throw in China’s continued slow down and it becomes incredibly difficult to be bullish on risk assets for the remainder of the year.

Stimulus in China is loosing its effectiveness at an alarming rate. M1 is exploding past M2.

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Which has put increasing pressure on China’s FX reserves.

This money growth isn’t showing up in the real economy as private fixed asset investment plummets.

FAI

Which is certainly not due to a lack of available money. China’s corporate cash holdings are at record highs.

Cash

If China wants to make it to the People’s Congress next autumn, it will need a bigger stimulus package.

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Thus capital flight out of china China should re-accelerate, pushing the RMB lower. China the world’s 2nd largest economy can ill-afford a Fed rate hike.

In essence, things look pretty grim for Japan. The domestic options for weakening the Yen in a sustained an controllable manner seem non existent right now. Without external help the Yen will continue to strengthen which will increase the stress on Japan’s fragile economic and further accelerate capital flows into Japan.

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From zerohedge: “The biggest driver of the collapse of Japanese trade was a 44% crash in the Chinese trade balance.” Which brings me to an important but often overlooked cross rate – CNYJPY.

CNYJPY

Having retraced over 60% of its 2012 up move, this trend is strong to the downside. With China forced to weaken its currency while Japan’s strengthens, I see no reason for this to change… UNLESS

The BOJ commits a major policy error. The probability of such an event is certainly on the rise. The central planners who have micromanaged their economy to a “t” are not going to sit idle as their economy implodes. They will break the market if they have to, because only then will they stop.

Negatives rates clearly haven’t had the desired effect in Japan. The Yen has considerably strengthened against the dollar since the BOJ implemented NIRP on January 29th of this year.

What if the BOJ beats the Fed to the next rate hike? No asset in the world has priced in such an event. I’m not saying they will do it, but what other options do they have? They will be compelled to try something.

Can they buy more bonds here? Not really. They are also running out of Japanese companies to buy. According to Bloomberg, the BOJ will become the top shareholder in 55 companies by the end of 2017. Fiscal stimulus was a dud. Maybe they can print yen, buy dollars and reignite the global currency war. 

This is where I begin to worry about my position in US treasuries, which looks terrible from a risk reward perspective. I knowingly invested in a bubble and have now decided to exit.

Central banks are fast approaching their limits which will bring into question the logic of buying negative yielding paper. Throw in the fact that the momentum leading this bubble has started to fade. The following chart from Jesse Felder shows how over extended US treasuries are.

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I’m not saying this it the low in US bond yields, but for now I don’t see a reason to own them. US treasuries have been tracking gold quite well this year. Which leads me to believe that the search for yield has been a significant contributor to the appreciation in gold.

What happens in a rate rising environment where yields rise, even if temporary. Gold from that perspective could take a hit. Gold could even fall in a rising inflationary environment (remember 2013).

The possibility of shorting bonds to hedge my gold position looks to be an interesting option. I’m not sure I’m there yet and instead would rather focus on US equity volatility or the lack there of.

 

Well this is odd. The S&P 500 broke out of a 19 month trading range that suggests a much bigger move is coming and yet volatility is incredibly low due to a record short speculative position.

VIX

At the same time investors hold a record long position in call options.

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I’ve been a bear on US equities for a while now, and it’s hard to find a better time to go short than right now. From a technical, global macro, and sentiment perspective, this looks like a great opportunity to short. It’s times like now to add on.

So that’s it for now. I wandered quite a bit, but I think I covered the old bull case. Now I must find a new one to better hedge my portfolio. There certainly are interesting options as it would be nice to have a better short term inflation hedge than gold which has been behaving more like a bond. I remain intrigued by the possibility of shorting bonds, or perhaps purchasing more oil exposure as a hedge for a falling dollar which pushes up inflation.

 

 

The Hidden War

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The two most powerful forces on earth are locked in an epic struggle, the outcome of which will determine the fate of mankind. It’s human stupidity versus human ingenuity, and the stakes have never been higher.

What reads like a log line for a Hollywood blockbuster film is actually the current state of the world. Governments, corporations, private citizens and everyone and everything in between has borrowed more than they can ever hope to pay back with current technology.

This is nothing new. We borrow money under the belief that we will be more productive with it than the rate of interest we pay on said debt. Unfortunately, that’s not the case right now as US productivity growth has been on its longest losing streak since 1979.

Although real interest rates are negative in the US, so is it that surprising that productivity is also negative?

When you consider that this US economic expansion which is nearing the end of its cycle has operated on zero interest rates the whole time it is even less surprising that investments don’t offer the same returns they once did.

There’s a running joke that the only way we get out of this mess is for someone to invent cold fusion (unlimited free energy). Now that would certainly do the trick, but there are a surprising number of game changing inventions just over the horizon that will change our lives beyond comprehension. Graphene, big data, artificial intelligence, driver-less cars that run on electrons, epigenetics, the list goes on and on.

The question as always comes down to timing. Can technology and innovation deliver us from myopic central banking policy? Over the short term, I have serious doubts. Most of these technologies are years away from significantly impacting our lives meanwhile global credit conditions continue to deteriorate at an alarming rate.

It’s important to highlight this hidden war, because it underscores the vital importance of science and technology in not just forwarding human progress but maintaining social stability and global peace. It is my hope that the future will be determined by those who unshackle us from our past mistakes and not those who bind us with misguided policies.

 

The Bond Plateau

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Can you feel it? There’s been an awakening. A shift in the world of investing that will bring about unforeseen change. A dusty cobweb covered switch in some far off corner of the investor’s brain was finally flipped on.

At the start of the year, Goldman Sachs and most other big firms were predicting US interest rates to rise. Now no one is. It has reached the point that investors aren’t even willing to sell their bonds to a price insensitive buyer such as the BOE. From zerohedge:

“Longer-dated bonds are “an area where people are hunting down what yield is left – you have to extend out into that area to get anything really,” Aberdeen’s Hickmore said. Carney “is going to say ‘it’s very early days, this is day one of the long-end purchasing.”

Investors chief concern these days is “what if interest rates never rise”. That’s right, bonds have reached a permanently high plateau. Of course we only need to look back a few decades to know this doesn’t hold.

With that said, I think a congratulations is in order for our unbelievable central bankers. Like Arnold Schwarzenegger covering himself with mud to hide his body heat from The Predator, the central bankers have blinded investors to risk.

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This potentially final embrace of central banking policy comes at the very heels of a growing movement of people (myself included) who doubt the efficacy of central banking policy. After the Japanese implemented negative interest rates, it seemed the market was finally fighting back. However as Morpheus notes…

22d

 

But perhaps people should not mistake a battle for the war. Investors have proven quite capable of buying anything with a yield as long as there is no perceived risk. The funny thing about risk is that you don’t know you have it till it happens.

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Wouldn’t you know? Global defaults in 2016 have already reached its second highest level in the last 12 years. Delinquencies on commercial and industrial loans is also spiking to crisis levels. Is now really the time to blindly plunge into corporate credit?

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Of course this perceived lack of risk is a fallacy, and the question then becomes, when does risk actually matter? Which brings me back to the irony of this potentially final embrace of central banking policy. Pension funds have piled on the risk to maintain their mandated returns.p1-bx524_penris_9u_20160531120608

It’s important to note that I have no idea when this will end. The nature of irrational behavior is that it is fickle and unpredictable. The end result may be obvious but our journey there is anything but.

But every crisis is an opportunity and as long as investors are blind to risk and desperate for yields some pretty interesting investments that I already own become that much more desirable – energy storage and solar and wind power. These three technologies allow investors to not only get a positive yield, but with very low risk.

If you live in an area like Arizona or Texas or California where the electricity rates vary tremendously by the hour, you can charge up a battery during off hours and use that energy during peak hours.

Depending on your location an investment in a energy storage will save you at least 7% of your investment per year in electricity costs. Over the longer term increased battery storage capacity would obviously narrow the gap between off and peak electricity rates but that added benefit is beyond the time horizon of this post.

Demand for wind and solar is absolutely exploding right now.  Just 3 years ago, the US installed its 10th GW of solar power, and now the US has 10 GW of utility-scale PV projects under construction.

And as the technology improves, so too does the yield. I’ve already discussed how the costs of solar panels is set to fall. Solar panels and wind turbines are also becoming more efficient. Set against the back drop of falling sovereign bond yields, the rising yields on these technologies and their supply chains look even more attractive.

I briefly diverged away from the consequences of this “bond plateau” but rest assured there will be many more, most unforeseen. Whether that means green technology or Irish REITs or some other exotic asset, there will be other ways to profit from this irrational behavior.

It’s important to remember that irrational behavior is also incredibly volatile, and yet US equity volatility is near record lows. The risk reward on that trade looks spectacular.

Alas the purpose of this post was to bring to your attention the mindset that plagues investors today and adjust accordingly.