Perception is Reality… by Brian Kelly

The consensus view is that the Spanish will be the next target if they are unable to get their fiscal house in order. While we will not dispute the fragile state of Queen Sofia’s monarchy we believe the bigger problem is the UK. Queen Elizabeth has a rapidly rising debt load while revenues are declining.

We were surprised and concerned how rapidly the markets moved from Greece to the UK – bi-passing Spain. The action in the British Pound has been nothing short or astounding. Now it appears the debt market is getting into the act.

Since the beginning of February UK bond yields have been rising at a faster pace than the yields on Spanish bonds. When compared with German Bunds, UK borrowing costs are 10 bps higher than Spanish borrowing costs. To be sure neither country faces the lofty cost of financing of Greece, however it only took 90 days for Greek bond yields to jump.

We are playing the rising bond yields by selling short the GBPUSD pair – once again we might be sounding counter-intuitive. The key is the reason for the rise – UK bond spreads are rising because investors are concerned Britain will not be able to pay its bills. On the surface this is the Greek contagion – BUT there is a huge difference – the UK can print its own currency. It is the printing press that makes us bearish on the British Pound.

We are short GBPUSD and anticipate remaining in this position for some time.

Long and Wrong in The Land of the Rising Sun
We have been long USDJPY on the view that interest rate differentials will favor the USD. Furthermore, the Japanese government and BOJ have publicly endorsed a weaker Yen. Alas, this position has worked against us.

The primary reason for the under-performance has been the use of the US Dollar as a funding currency in the so-called carry trade. The benchmark rate for this trade is the 3 Month LIBOR rate – since August 2009 the US Dollar has been cheaper to borrow than the Japanese Yen.

That all changed when the USD 3 month LIBOR climbed above the 3 Month Yen LIBOR. In our view this is a significant change that could lead to a marked appreciation in the USDJPY pair.

Any remaining US Dollar funded carry trades will now be unwound in favor of the Yen. Moreover, the Japanese debt load and political disharmony could easily lead to a situation similar to Greece – with the caveat that Japan can print money. The printing press is once again the catalyst for our short position in the currency.

Additionally, both the BoJ and central government desire a weaker Yen to help with debt load and exports. Therefore, there will be political and central bank tailwinds and few headwinds.

Disclosure: Short EURUSD, Long USDJPY

Act II
We have been writing about the Hellenic Republic for several months – the ultimate resolution is much as we anticipated, however we miscalculated how long Act II would last.

From the January 28th Divergent View -

We have resisted the all too obvious references to a certain type of Greek theater when describing the goings on in the Hellenic Republic. Although we refuse to succumb to temptation, there is a device employed by the chorus – during the aforementioned nameless art form – which signaled a turning point.

Antistrophe – roughly translated – means counter-turning or counter-circling and was the device used by the Greek chorus to indicate a time of change. Importantly it was only the second of three acts by the chorus. Today, we find the global markets at just such a point.

At that point in time we thought a bail-out, rescue package or financial help was only a matter of days away. A month later we are still waiting – nonetheless it does appear the EU and Greece are heading toward an agreement.

More importantly, the market is beginning to believe in the resolution of the Greek debt problems. For the first time in a month Greek bond spreads over German Bunds have dropped below 300 bps – bringing Greece’s borrowing cost much closer to the rest of Europe.

As the bond spread compresses it is likely Greece will come to market with a 10 year bond deal. A press conference is scheduled for Friday with Angela Merkel in Berlin as Act II ends.

If the “bail-out” includes debt guarantees by German banks then we would argue Greek bonds are the equivalent of German Bunds. We suspect the market will not see it this way for one very good reason – public acceptance of austerity measures. Greek leaders agreed to austerity measures because they have no other choice – European leaders will agree to backstop Greece because they have no other choice – BUT public acceptance is the wild card. Act III will be focused on implementation of the new budgetary measures.

Act III
Despite Greek and European officials having no choice in the matter they have done a remarkable job of heightening the drama. Almost two months of name calling, insults and threats have culminated in this week’s turning point. While Act II is ending there are signs Act III may be even more difficult to navigate. As the politicians meet, taxi drivers are on strike and blocking the streets of Athens – we expect to see more of this behavior as the government attempts to implement the belt tightening.

There is a bit of a ballet being performed by Greece and the EU – both understand that Greece needs to come to market with a debt deal within the next 6 weeks – the timing is key to the ultimate outcome of Act III.

If Greece receives the money before austerity measures are implemented then there is less of an incentive to actually enforce the new rules. Moreover, the general public will lose any sense of fiscal urgency (if that ever existed). It is for this reason that we shall be looking to take profits in NBG, CS, DB and EWP as a debt deal nears.

The best outcome for our positions would be a debt deal this week – however, we would view this as a long term negative as it would erode any leverage the EU has over Greece’s belt tightening. The best outcome for our positions may not be the best outcome for the EU and the markets as a whole.

Disclosures: long nbg,cs,db,ewp

One of our favorite forward looking economic indicators is the Chicago Fed National Activity Index (CFNAI) – comprised of 85 separate economic times series this indicator predicted the Great Recession began in December 2007 – 8 months before the NBER. On the indicator’s 10th anniversary, the Chicago Fed has released a study of its ability to forecast GDP and inflation – the results are rather impressive and can be found here.

The most recent release of the CFNAI indicated economic activity continued to accelerate and Q1 GDP would be relative robust. We find this indicator so powerful that it is almost enough to change our decidedly cautious stance on US equities.

BUT the ultimate judge is the market and investor reaction to news – the reaction this earnings season has been less than enthusiastic. Companies have beat on the bottom line, matched on revenues and still get sold off. Almost exclusively the reason for the earnings related weakness is the outlook for the second half of 2010.

The most recent victims are Radio Shack (RSH) and Nordstrom (JWN) – both companies posted respectable earnings, but warned of a slowdown in the second half of the year. These negative second half forecasts are in contrast to the conventional economic wisdom that the yet to be enacted stimulus programs will kick in and complete the hand-off from government spending to private consumption.

The second half concerns are consistent with our view of significant economic headwinds as a result of household de-leveraging. We view the financial crisis as the end of multi-decade credit expansion cycle which began after World War II. This will be the first time since Great Depression the US economy has emerged from recession without the economic tailwind of credit expansion.

In light of this view, and despite the CFNAI robust forecast, we remain cautious on US equities especially as the pages of the calendar disappear.

Disclosures: Long SDS, Short JWN

In our younger years we were quite accomplished at the “Match Game” on Sesame Street – to some we have just hopelessly dated ourselves, to others we hope to have given you a nostalgic boost. Whichever group you find yourself, please indulge us as we revert to times past and play the game once again…

German PMI – Manufacturing & Services, both rising….

Euro-zone PMI – Manufacturing & Services, both rising…

UK PMI – Manufacturing & Services…

Do you see it? For those pattern challenged we shall spell it out…the UK service sector has begun to contract.

So why did we drag you back a few decades only to point out that one forward looking indicator has begun to roll over? Because Greece is just a sideshow compared to the UK. As we wrote in our Special Report on Greece, the problems of the Hellenic Republic will be resolved (the EU has no choice) and the whole experience can be used as a blueprint for debt issues in the UK and Japan.

Greece needs to raise ~55 billion euros this year – in the last auction the country received bids for almost 25 billion. As a percentage of GDP, Greece’s budget deficit is close to 12% – although we doubt that all the debt has been counted. As a comparison, the IMF estimates the UK budget deficit to be 13.3% of GDP. Not too bad…until one considers that UK GDP is $2.3 trillion!

This is why we are worried about the UK service sector rolling over. If the UK economy cannot mount a sustainable recovery then the ability to sell debt could be severely compromised. As the market is now focused on Portugal and Spain – they too will be sideshows once the market focuses on the UK.

Disclosures: short EURUSD

We have resisted the all too obvious references to a certain type of Greek theater when describing the goings on in the Hellenic Republic. Although we refuse to succumb to temptation, there is a device employed by the chorus – during the aforementioned nameless art form – which signaled a turning point.

Antistrophe – roughly translated – means counter-turning or counter-circling and was the device used by the Greek chorus to indicate a time of change. Importantly it was only the second of three acts by the chorus. We now find the global markets at just such a point.

Both The Economist and Le Monde have reported that a bail out of Greece by the European Union is not a matter of if, but when. This is the same conclusion that we presented a fortnight ago in our Special Report on Greece and the Euro, i.e. Greece would not go bankrupt. Any “bail out” of Greece will need to be politically palatable to Germany, while also repeatable in the case Portugal or Spain needs a helping hand. Greece and the other porcine pals must be bailed out or the structure of the EU is at risk. We see this as only act II of a three act play.

At this turning point, Greece will be presented with a financing plan that will require severe austerity measures. Greek leaders will accept because – frankly – there are no other alternatives. However, act 3 will commence when the Greek leadership presents and implements this belt tightening. That the Greek political system is tainted is not unknown – but the political and popular acceptance of change remains a formidable wild card.

There are a few key dates over the next month, February 10 and the 11. On the 10th a general strike is planned by Greek civil servants to protest austerity measures already proposed – in the past, the strikes have led to violent civil unrest. On the 11th, an informal economic summit of EU leaders is scheduled in Brussels – which will no doubt focus on the porcine pals.

These dates and events are the basis of our hypothesis that this is only the antistrophe to be followed by the epode, or after-song. During this period, we expect a period of EURUSD strength – as markets anticipate a deal, shorts will be covered and new long bets established.

Disclosures: Short EURUSD

The trillion dollar question for the financial markets is whether or not the global economy is strong enough to accept the hand-off from central bank and government stimulus. After 15+ years trading the financial markets we have found only one statement of truth…things change.

To that end we thought it would be not only instructive, but also financially necessary, to look at some of the drivers of the global bull run…away we go….

Chinese Growth is Boosting Global Trade
Market orthodoxy is that Chinese GDP at 10.7% is enough to keep global trade afloat. We concede that an inventory restocking cycle has occurred which can be seen in the rising Baltic Dry Index during October and November. However, if the the restocking cycle is supposed to hand-off to normalized trade, then why has the BDI dropped almost 1500 points since November?

Yes, BDI is a volatile index which may or may not reflect the actual prices paid to charter a ship, but for our purposes it is the direction that counts. If global trade is picking up, the direction of the BDI should be up, not down.

Something must be askew, are there other market based indicators that might support or debunk the message of the BDI? Glad you asked…

With one of the largest and busiest ports in the world, Singapore is a hub of global trade. It is for this reason that we use the Singapore dollar as a proxy for market sentiment on trade. During October-November 2009, the USD was weaker against the Singapore dollar suggesting demand for the SGD. However, over the last few days the Singapore dollar has been significantly weaker v. the dollar implying investors are betting against global growth.

Ah, you say, but the Chinese stimulus package is aimed at the domestic economy. Quite true, and we would add the consensus view is a housing bubble is developing in China …maybe…

The last time we checked the primary characteristic of a bubble was prices at record highs. If the Chinese real estate market is acting like Mark Cuban circa 1999, why does the Shanghai property index look like it is about to breakdown?

Additionally, construction and over building deplete inventories of raw materials – that would mean LME warehouse stocks of copper and aluminum should be at historic lows.

Hmmm…Copper stocks approaching 5 year highs!!!

These are not the pictures of a healthy Chinese or global economy. Once upon a time, a popular economic catch phrase was “if the US economy sneezes, the world economy catches a cold.” These pictures leave us wondering what happens if China gets the sniffles?

Germany Has Weathered the Economic Storm and Will Carry European Growth

It was only a few days ago that we suggested economic growth in Germany was probably one of the biggest threats to the Eurozone. Our hypothesis was that economic growth in Germany would lead to inflationary pressures and cause the ECB to tighten policy – at the same time – periphery Europe would still be struggling and need loose monetary policy.

Our assumption of German growth was based on the idea that as one of the largest exporting countries in the world Germany has been and would continue to be a prime beneficiary of global growth.

Indeed, German PMI – Manufacturing has recovered robustly. If Keynesian theory is correct then the service sector should begin running with the ball. Unfortunately, German PMI -Services has continued to decline from its September peak.

Furthermore, the economic weakness is not limited to Germany, it appears to be spreading to the Eurozone as a whole.
Eurozone PMI -Services has also begun to decline. To be sure, one data point does not make a trend, but when coupled with tighter Chinese lending, a falling BDI and rising dollar it does not flatter the global economic picture.

Disclosures: Long USDSGD

Have you ever watched someone on CNBC and still had a few more questions????? Me too!!!!

I will be on CNBC today at 9:20 am and then will host a LIVE BLOG at 10:30 am at www.instividualinvestor.com.

Please join the discussion – talk about anything I said on CNBC or any other market subject!

I look forward to your participation.

-BK

On CNBC’s Fast Money New Year’s Eve, I was asked to give my “surprise” for 2010. What was it?

Japanese Equities outperform all other markets in 2010.

There are three pillars supporting this view:

“Good Enough”

One of the only data points for Japan last week was the release of Japanese Industrial Production. The number was nothing short of fantastic as the monthly change was positive and the yearly number was significantly less bad.

On the stellar number the Yen went absolutely nowhere! The markets have interpreted the number as good enough to keep Japan out of debt service trouble. However, most of the gain was due to exports to Asia.

Quantitative Easing
Domestically, the economy is still weak which should give the BoJ the political fuel they need to keep rates low and fight deflation via quantitative easing. The economic developments in Japan are playing out very similarly to the United States in March 2009. Industry is ramping up as a result of government spending, but has yet to filter into the domestic economy.

Like the US, we expect the Japanese currency to weaken as quantitative easing gains traction and the US dollar carry trade is unwound in favor of the Yen carry trade.

Liquidity Fueled Rally

A weaker Yen supports Japanese exporters and will likely be embraced by both the BoJ and the Japanese government. What’s more, a improving economy, especially China, will add to exports and help Japanese companies. The combination of low interest rates and improving export prospects could fuel a rally similar to the one experienced by the US since March 2009.

Disclosures: We are short Yen v. long US Dollars via a short position in FXY and Long EWJ

Just before the Christmas holiday the SEC gave base metals investors a nice present in the form of approval of a platinum and palladium ETF. To be sure, this news was not unexpected, but it put a significant bid in the PGM market.

As a comparison, we looked at gold’s reaction to the listing of the SPDR Gold ETF. In November 2004, GLD began trading on the NYSE; gold was trading at $450 an ounce.

Over the next 6 years, gold almost tripled in price as demand surged and the dollar fell. The weak US dollar coupled with rising demand created optimal growing conditions for the yellow metal. We see a similar occurrence in the PGMs.

Platinum and palladium are key ingredients in auto manufacturing as well as a plethora of industrial uses. As the global economy recovers, demand for these industrial metals should begin to rise. In fact, the recent run-up in prices is a result of the anticipated surge in demand. We have been playing the rise in palladium via a long position in North American Palladium (PAL).

We have been long this position for quite some time and will hold until at least our target of $3.80 has been hit.

Disclosures: Long PAL

As the OPEC meeting concluded in Angola we found two take aways from the OPEC meeting in Angola: Asian demand is strong and $70 is the new floor in oil prices.

Demand from Asia (China) has been stronger than expected, while OECD demand has not climbed as much as expected. It is the combination of Chinese and North American demand that could push the oil market into deficit.

Chinese economic data is tracking much better than expected. To be sure, there are question about the validity, but OPEC’s acknowledgment of increased Asian demand suggests the trend is higher.

The second takeaway comes courtesy of the Saudi oil minister who stated that oil between $70-$80 is “perfect”. In some respects we agree. Oil prices in this range encourage investment in production and finances many of the worlds governments.

As the largest producer in OPEC, the Saudi admission that $70-$80 is “perfect” implies that OPEC will attempt to keep $70 as the floor in oil prices. Technically, a close above $75.65 will confirm that a new uptrend has begun.

Disclosure: Long USO