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

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

On the North Shore of Oahu there is a wave known as Pipeline. Large Pacific Ocean swells travel thousands of miles only to crash upon the jagged reef. The collision results in a near perfect wave revered by surfers for its “tube” or “greenroom”.

The most skillful board riders from around the world flock to this beach in hopes of catching the wave and entering the greenroom only to be spit out the other end. Some are successful…others not so much.

Success depends on their ability to focus on a singular task. Chairman Bernanke faces a similar challenge, but lacks the luxury of focusing on only one objective. The Chairman not only must promote “maximum employment” but he also must foster “price stability”. At this point in the economic cycle these two objectives require two different policies.

In Novemebr, Chairman Bernanke gave an eloquent speech about the current and future state of the economy. For us, the key part of the speech as it relates to the US Dollar and inflation was:

We are attentive to implications of changes in the value of the dollar and will continue to formulate policy to guard against risks to our dual mandate to foster both maximum employment and price stability,

We read this as the Fed saying they are acutely aware of the impact of a weak dollar and that the Fed may act to curb inflation to ensure price stability. The Fed has already hinted that a tightening of policy may occur sooner than traditionally anticipated.

Now we must look for signs of inflation as well as signs of job improvement. The inflation data in the form of the headline producer price index did not scream inflation, the sub-indices are beginning to show pricing pressures.

Prices for intermediate goods climbed for the 3rd month by 0.3%. The primary culprit for this increase was a 5.5% rise in diesel fuel prices. As of know, the increase in diesel prices have not been passed onto consumers.

But the big jump was in crude goods, which rose 5.4% in October. Interestingly, the rise in crude goods was due to broad based price increases, not just energy. This is the first sign of inflationary pressure in the pipeline. If the Chairman is not focused, this pressure may indeed spit him and the US economy onto the jagged inflationary reef.

Disclosure: Long TBT

Most of the investment world prefers to operate “ex-Japan”. Indexes, funds and research are all labeled Asia (ex-Japan). So why do we care about Japan? Because Japan not only offers a road map for the impact of quantitative easing, it also offers a preview of what the world could face.

First, a bit of history. In 2001, the Bank of Japan lowered its interest rate to zero, within one month of this move the BOJ enacted quantitative easing. The goal of the QE was to increase bank reserves by purchasing government securities in the open market. Sound familiar? It should.

The US Federal Reserve has conducted the exact same policy, with the exact same results. As the economy deteriorated, the BoJ bought more bonds and increased reserves. In fact, reserves peaked at ¥35 trillion, of which only ¥8 trillion were required. Sound familiar? It should.

Excess reserves in the US have just breached the $1 trillion level. Like the BoJ, the US Federal Reserve has been operating under the assumption that providing liquidity will result in more bank lending. This assumption proved false in Japan, and is so far proving false in the United States. Over the last year, the amount of loans and leases at commercial banks has been falling, the exact opposite of the Fed’s assumption.

In Japan and the US, the argument could be made that demand for loans also fell as companies cut costs and were able to self-finance through cash-flow. Additionally, low rates made the corporate bond market more attractive.

After 5 years of quantitative easing, the Japanese economy has once again dropped into deflation. This means that the formidable Japanese Government debt is getting more expensive, even if the BoJ keeps rates low until 2012.

The result has been ultra-low short term rates and a rolling flattening of the Japanese yield curve. In fact, short term Japanese rates are so low that Nomura Securities increased the average duration of its Bond Performance Index. This means that money managers, like the Japanese Government Pension Fund, must buy longer dated securities to match the duration of the benchmark index. The net result is a rolling flattening of the curve. As investors reach for yield they must look further out on the yield curve.

The unintended consequence could be that investors reach for yield further out on the US Treasury curve. This coupled with record low holdings of Treasuries by banks and a VERY crowded short Treasury trade could produce a bond bubble. Not surprisingly, the same thing happened in Japan and may indeed happen again with the announcement of a new round of QE.

We are not quite ready to declare an upcoming bond bubble in the US, but it does impact our immediate investment strategy. The low yields could spur demand for higher yield equities, which may indeed support the market for the rest of the year. We are playing this by purchasing high yielding utility stocks.

Disclosures: Long XLU and PEG

The traditional economic orthodoxy suggests that unemployment is a lagging indicator, since firms do not begin hiring until they are sure a recovery has begun. However, the length and depth of this recession has resulted in unemployment morphing into a leading indicator.

Consumer confidence can be viewed as a leading indicator for potential demand, but the report released on Tuesday contained some of the worst data in the 40 year history of the index. The primary reason for the decline in confidence is the belief that jobs are hard to get. To be sure, this is precisely why unemployment is a lagging indicator because even though there is economic improvement firms have yet to hire, thus depression the consumer.

The difference this time is that the length of the recession has resulted in consumers adjusting buying expectations. According to the Conference Board, buying plans for cars and appliances have all been revised down by the consumer. This was reflected in the durable goods orders and may be reflected in the GDP report to be released Thursday.

Disclosures: none

We would expect that of the economy were truly picking up steam (notice the foreshadowing) then railcar loadings would be climbing.

Not only has total rail traffic failed to begin its seasonal upturn, loadings of crushed stone and lumber are falling. These are signs of an economy that is stalling.

Disclosures: none

The economic data released last week painted an picture that may best suited for the ice cream shop…a double dip. Atrocious employment, weak durable goods orders and falling new orders in the ISM index have us questioning whether the economic pain is really over.

This time last year, we were riveted to our computer and television screens wondering which company would be the next to need a bailout. The policy of too big to fail was in full swing.

This autumn we are faced with the foreboding task of deciphering the latest economic data to determine the next economic path. Our favorite leading economic indicator, the M1 multiplier, will be our light through this valley of darkness.

Over the last month, the M1 multiplier has continued to fall suggesting the economy is not expected to get any better. We wrote a month ago about the decline in the M1 multiplier and its implications for the economy. Recall that the M1 multiplier has correlated with the path of the economy 6 months ahead 96% of the time since the 1950’s.

Part of the reason for the decline in the M1 multiplier is M1 itself. M1 is falling suggesting the American public has less money to spend.

At the same time the monetary base is rising to record highs.

The cause of the rise in the monetary base is a dramatic rise in bank reserves.

The implication of higher reserve balances is that banks find it more profitable to hold money at the Federal Reserve than to lend it out. Of course this leaves the economy even more desperate for credit. The lack of credit is clearly hurting profits which normally would help boost M1, but as we have seen, M1 is declining, suggesting profits are declining.

Examining the amount of loans, leases and credit commercial banks are extending we find the number to be falling to the lowest levels all year.

Our concern is that the banks unwillingness to lend is creating a stealth credit crunch among small businesses. This credit crunch resembles the more visible crunch experienced by large corporations last fall. The difference is, small businesses are not too big to fail.

Disclosures: None

As the G20 concludes and the US equity markets decline, the US dollar is playing pivotal role in both the foreign currency markets and geo-political posturing. Last fall, during the height of the economic crisis the US dollar index broke a 6 year downtrend which began in 2002. As the dollar peaked in March 2009, the US equity markets began to find firmer footing and the year long relationship between the dollar and equities blossomed.

US Dollar Index (Cash) – Monthly Chart

Over the last 6 months the Us dollar index has declined in what may turn out to be a correction. Furthermore, over the last 6 months both the implied volatility and historic volatility have been cut in half from above 20% to below 10%.

Implied Volatility and Historic Volatility on US Dollar Index Futures Options

We also note that since the beginning of September the implied volatility index has climbed substantially above the historic volatility. The implication is option traders have been expecting a big move in the dollar index.

While implied volatility tells us what the market is expecting it does not tell us the direction of the expected volatility. In the US dollar index, the implied volatility on both the puts and the calls have been rising in tandem, which means they offer little information for directional analysis.

Combining the technical and volatility analysis we deduce the likelihood of a dollar reversal has increased significantly. Adding the weakness in the US equity markets fortifies our conclusion. Just as the weak dollar fueled the rise in the equity markets it is possible that the strong dollar fuels a decline.

The two markets can form a vicious circle that mirrors the action we have seen over the last 6 months. The stronger the dollar gets the weaker the equity markets become, this weakness in turn causes a flight to safety and the dollar becomes stronger.

But what is the fundamental fuel for a rising dollar? Glad you asked. To complete this analysis we must distinguish between a benevolent dollar rise and a malevolent rise.

Benevolent Fundamental Reason for Dollar Strength
Under the benevolent scenario, the dollar strengthens because the US economy is improving and the Fed begins to drain liquidity. The markets anticipate the “tightening” and begin to bet a rate increase is next, thus making the dollar a higher yielding currency. We have seen this type of reaction to the Fed’s most recent statements on reverse repos.

For the last few days, stories have “leaked” that the Fed will conduct reverse repos to drain liquidity from the system. First it was leaked that these action would be conducted with primary dealers. Then, money market funds were targeted as the object of the Fed’s affection. Conveniently, the “leaked” stories also mentioned the Fed may want to conduct a few tests but were afraid of spooking the markets. Now that the news has been released we expect to see a few “tests” conducted which may be the first catalyst for significant dollar strength.

In this case the equity markets will fall initially as investors digest the new paradigm. Once investors realize the rising dollar is due to improved economic conditions they will once again purchase equities and we can begin a new phase of the bull run.

Malevolent Fundamental Reason for Dollar Strength
The other side of the coin is the unhappy reasons for a strong dollar. We see the catalyst for this to be a weak economic event. It could come from commercial mortgages, it could come from increased taxes, and it could come from protectionism. Sadly, we can find more malevolent reasons the dollar could strengthen than benevolent.

Regardless of the reason, under the malevolent scenario the rising dollar reduces the profit margins of US multinationals which get a majority of their revenue from overseas. The reduced margins results in further layoffs and the economy suffers a double dip recession. In this scenario, the US equity markets would continue to decline and likely trade well below the March 2009 lows.

The US equity markets and the US dollar are still attached at the hip. The real question that investors must ask themselves is whether or not a stronger dollar is a signal of fear or economic improvement.

Disclosure: Long UUP