Perception is Reality… by Brian Kelly

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

Just as the US 2-10 Spread hit all time highs, the bond markets rallied as the equity markets swooned. The more aggressive buying was found in the short end of the curve, especially the 2 year notes which have been the safe haven of choice over the last year. 

We view this move as the start of minor correction on the march toward 5%. There was however, some interesting news out of Basel and the Bank of England.

We wrote a few weeks ago that if banks were required to hold more capital in government bonds then a massive bond bubble could occur.

Not surprisingly, one of the recommendations of the Basel Committee on Banking Supervision (Basel III) was that banks hold more capital in safer assets. Guess what they define as “safe” assets…yep, sovereign debt!  Additionally, the Bank of England’s Financial Stability Report suggested banks take advantage of current favorable market conditions to raise excess capital. Where would this “excess” capital be stored? Government bonds.

The risk in this policy is that as banks buy government bonds they support the price and keep government borrowing costs low.  These low borrowing costs and ease of financing discourage fiscal austerity. At the same time, the supportive bank buying makes the government bonds appear to be “safe” as they continue to rise.  Eventually, bank vaults are full of government paper and the buying ends, governments cannot finance bloated spending and the bond bubble bursts. Greece has given us a minor preview of what could occur.

To be sure, it is MUCH too early to declare a bond bubble is on the horizon.  The Basel III recommendations have just been released and are now out for comment until April. Over the next few months we expect more banking regulators to latch onto the idea that government bonds need to be a larger part of bank balance sheets. If the drumbeat is loud enough and the public begins to listen, then we shall begin to look for signs these recommendations will become law.

Disclosure: Long TBT

The US dollar has appreciated significantly on fears that the developed Europe may indeed be coming apart at the seams. S&P downgraded Greece (again) and the Prime Minister did the rounds on business television like an actor with a new movie. 

Moreover,as a result of Greece, the ECB is now conducting a review of collateral and the the use of funds dispersed under the liquidity program. In a “wonderfully” self-serving move, Greece has been giving the ECB its junk loans in exchange for fresh cash. The unspoiled cash was then used to buy Greek government bonds which kept borrowing costs low and diminished the need for Greece to tighten its fiscal belt.

The jig is now up.  In the words of Ricky Ricardo…”you have some ’splainin’ to do.” The danger is that in its rage, the ECB risks cutting off funding to Greece just as it needs it most.  It is this fear that has the Euro down and the Dollar up.

Not to be outdone by their continental brethren, the UK served up some weak retail sales. This news came as a surprise, especially
after jobless claims dropped in the UK on Wednesday.

The weakness in retail sales has reminded investors that the UK also needs economic growth to pay its substantial debt load.

The net result of the action in Europe is a broadly stronger Dollar v. the Pound and the Euro. On a hourly basis, the DXY has now broken its channel to the upside. As a rule of thumb, when markets “go parabolic” they are ripe for a correction.

Disclosures: We remain long UUP, and short FXB, FXF and FXY and anticipate holding these positions through the inevitable and numerous corrections that will come over the next few months.

As the global economy continues down the road to recovery and pesky sovereign default issues arise, the US Dollar has increasingly become the currency of choice for global investors. OK, perhaps currency of choice is too strong a characterization, but the reasons to be short the US Dollar continue to deteriorate. We have highlighted the improving US economy as one catalyst for US Dollar strength and we have speculated that the dollar carry trade may be unwinding.

The primary rate for funding the carry trade is the 3 month LIBOR rate. In August, the 3 month Dollar LIBOR rate dropped below the 3 month Yen LIBOR rate. The result was a depreciating dollar v. the yen and a jump in gold. As the BoJ enacted quantitative easing these two rates have once again begun to converge. It was this convergence that lead us to speculate the dollar carry trade was being unwound. Today, the 3 month Yen LIBOR is at 0.277 while the 3 Month Dollar LIBOR is at 0.28. The difference is negligible. Additionally, the BoJ has pledged to keep rates low and the US Fed meets this week. While we do not expect the Fed to raise rates this week, the trajectories of Japanese and US monetary policy are headed in two opposite directions.

Last week the US Dollar Index (DXY) broke its 9 month downtrend by closing above 76 for the week. The DXY has now found support at the 78.6% retracement level and broken a significant downtrend. This is precisely the action we had anticipated and is as much confirmation as one gets in the financial markets.

We now must look to the next area of resistance for the DXY. The 80 level represents formidable resistance as it has not been broken in over a year. Moreover, 80 has served as support since 1978! As we approach this level it will take a significant fundamental event to push the DXY through. Our leading candidate for this fundamental event is a withdrawal of QE by the Fed. In particular, an increase in the rate paid in excess reserves and/or reverse repos will be the first form of Fed tightening. While not a rate increase, these actions will be enough to convince the markets the Fed has ended the easing cycle and is about to commence tightening.

Disclosures: Long UUP, Short FXY, FXB,FXF