Perception is Reality… by Brian Kelly

Brian Kelly Responds to Doug Kass’ ‘Fast Money’ Challenge

Continue Reading Add comment June 7th, 2010

Where Do We Go From Here? Down.

From the outset of the financial crisis the response by central banks and governments has been pure Keynesian – if you print enough money you can reflate anything. The fatal flaw in Keynesian logic is that Lord Keynes assumed a government could borrow at will.  As we have seen in the last week, this is not always the case.

Our global financial system is based on the simple tenet of trust – one party contracts with another and trusts they will be made whole on the transaction. When that trust breaks down, the system breaks down…this is what we experienced Thursday in the financial markets.

While many will spend the weekend retracing the path that got us here, we find it more useful to look forward and determine the most likely path ahead.

The Eurozone Endgame – Debt Restructuring
As we wrote last week in our Special Report: Europe on the Edge of a Debt Crisis, we believe the ECB is negligently behind the curve and must act quickly and decisively to stem the panic. In this report we presented three scenarios from best to worst, unfortunately the ECB has chosen door #3 and the worst case scenario.  The ECB and the EU have failed to properly address this crisis by immediately enacting quantitative easing, cutting interest rates and generally restoring confidence in the system.

Under our worst case scenario we opined that the market would punish Europe severely for this misstep and would push the Eurozone into a full blown debt crisis…unfortunately the Eurozone has arrived at its destination.

Now that confidence has been lost the end game for Europe is a debt restructuring for Greece, Portugal and potentially Spain. A voluntary restructuring is what the market is demanding and it will not relent until it is satisfied. The so-called austerity measures being enacted rely heavily on economic growth in Europe, given the events of this week we do not believe even mild growth is achievable in the Euro-zone.

The net result of a Eurozone debt restructuring will be a significantly lower Euro.We presented the chart to the right to our institutional clients in January. At that time we added the caveat that if the ECB could short circuit the vicious spiral that was/is Greece then our targets may not be achievable.

The ECB has not only failed to short circuit the downward spiral they have added to the uncertainty. Given the social and political unrest in the Eurozone we believe a EURUSD rate at parity is well within the realm of possibility.

The “Flash Crash’ & The UK Endgame – Pound Devaluation
On Thursday the UK voters decided not to decide and stuck the UK with a hung parliament.  It appears that the worst of all scenarios has played out with not a single party have a clear mandate.  Over the next few days uncertainty will run rampant as the world watches the intracacies of a parliamentary system that will appear chaotic to the financial markets.

In the end, the UK has a formidable task on its hands – it must cut its budget enough to satisfy the ratings agencies -and more importantly the markets- while at the same time keeping the nascent economic recovery alive. The ‘Flash Crash’ may have been the straw that breaks the camels back. Confidence in the financial markets is shattered and any potential for the continuation of the bull run was deleted by yesterday’s robot ruckus. Given the fact that the UK economy is highly levered to the financial markets we do not believe the UK will be able to generate the GDP growth needed to keep its AAA rating.

The UK, unlike Greece, has the ability/luxury to print as many pounds as it wishes, therefore a debt restructuring is not likely. However we do believe the markets will continue to push the GBPUSD to our target of 1.2500.

US Equities? Lower
Simply put any hope that the retail investor would be the engine behind the next leg of the bull market vanished with the touch of a button.  Moreover, we do not believe in the myth of decoupling. Therefore, unless a miraculous solution to the European crisis arises over the weekend we do not foresee new highs any time soon for US equities.

In the begining of April we presented this chart with our ‘line in the sand’ of 1073 – at that point in time we did not believe that level would be achieved in one day!
Our technical view is that a close below 1073 would signal the end to the bull market and the begining of a significant correction at best and new downtrend at best.

The ultimate manifestation – downtred or correction – depends wholly on market confidence. We are quickly approaching the point of complete loss of confidence – if left unchecked a new downtrend will develop pushing the S&P 500 below the March 2009 lows.

Disclosures: short GBPUSD, EURUSD

Add comment May 8th, 2010

Greek Debt Restructuring Next?

The financial markets are finally figuring out that the so-called bail-out for Greece is flawed. Loyal readers will recall or March analysis of the three flaws- click HERE to read. In short, the bailout is based on increasing taxes, GDP growth and public acceptance…all of which appear to be long shots.

As the markets approach crisis, it has been reported that Greece has hired Lazard to give it financial advice.

The Consensus View – Lazard Will Advise Greece To Cut Its Spending
There is no doubt that Greece needs a financial adviser, after years of overspending they have gone beyond the point of no return. The party line is Lazard has been called in to help Greece cut its deficit and adhere to the required austerity measures.  Presumably this means telling Greece what they already know – public spending is out of control and the unions don’t care.

We question whether Lazard – or any other banker – has the ability to convince a population (prone to violent protests) that they must accept wage cuts because the corrupt politicians squandered their resources. In our view, this is a Herculean task that is beyond the scope of an investment bank. Make no mistake, we by no means are disparaging Lazard’s capabilities, we just believe the job may be better suited for Blackwater.

The Divergent View – Lazard Will Advise Greece to Restructure Its Debt
In our view, Lazard will quickly see the path of least resistance is to restructure Greek debt – in plain English this means debt holders will be forced to accept less money. The ratings agencies have already downgraded Hellenic debt to a level that would suggest a 30-50% haircut on existing debt. While this move would shock the markets- in the long run,  it would actually give Greece a fighting chance.

Several press reports and market chatter have implied that German private bankers have been meeting to discuss their role in the Greek bail-out.  Presumably, these meetings have been less about how German banks can help Greece and more about how German banks can stem their losses. As US mortgage banks have discovered, it is much better to proactively negotiate with your debtors than to let the market’s invisible hand steer the vehicle.

We believe the combination of German bank meetings and Lazard’s mandate is the precursor to a voluntary debt restructuring.  In light of this view, we are staying short the Euro and Deutsche Bank.

Disclosures: short Euro and DB

Add comment May 4th, 2010

Will a Moody’s Downgrade Be the Next Greek Shoe to Drop?

Add comment May 3rd, 2010

Is the Short Euro Trade Over…Nope!

Monday evening on Fast Money, we were asked if the short Euro trade was over – our answer was a definitive…NO! The primary driver of our confidence is the flawed structure of the current plan (if ‘no action’ can be called a plan) and the flawed structure within the Eurozone. The two flaws are a lack of an explicit contingent financing plan and the inability of the EU to enforce such a plan. These two flaws are interacting with each other to create a vicious downward spiral.

Our short Euro trade has served us well, but as the saying goes you are only as good as your last trade. Now the question becomes where does the spiral end and what is the catalyst for completion? We can zero in on the where part of the question using the technicals of the EURUSD pair.

Short, Sharp, and Sweet

The EURUSD has completed 4 of the 5 waves in the downtrend. In commodities and currencies the last and final wave (5) tends to be short in time, sharp in price movement and a sweet profit opportunity.

The move from 1.3818 in the EURUSD represents the first thrust of the final wave. Targets for wave 5 are generally 50%-61.8% of the total move from wave 1 through wave 3. Using this methodology the wave 5 target for the EURUSD is 1.2960 to 1.2760 – a considerable move lower.

While all currency trades are relative, it is also instructive to look at the US Dollar Index.

We have been long US Dollars since the Thanksgiving Day Dubai shock. The DXY has completed 4 of 5 waves up and the 5th wave appears to have begun. Using the same target methodology as the EURUSD pair, the target for the DXY is 83 – 83.90.

Now What..
We have answered the where question and now it is time to answer the what. What will be the catalyst to end the Euro slide? In short, a sustainable, scalable resolution the the Hellenic hoopla.

The previous sentence can be filed under “easier read, than done”. We have advocated a solution that makes aid to Greece contingent upon meeting certain budgetary goals. Moreover, this solution will be used as a blueprint for the rest of Europe, therefore it must be scalable. The recent chatter has centered around an IMF or joint IMF/EU solution to the problem.

An IMF solution would be both explicit and contingent upon austerity measures, thus it fits our first requirement. The unknown is the scalability – this is where the US gets involved. As the largest member of the IMF with the de facto reserve currency the scalability will come from the resources of the US – which is why we presented the DXY chart above.

IMF Bailout = US Bailout
While it is much too early to reasonably asses the final structure of an IMF solution – it is not much of a stretch to view IMF involvement in Europe as US Dollar negative. Given the precarious state of US government finances any additional debt would certainly cause investors to flee the US dollar.

The net result is that the longer the uncertainty remains the further the Euro will fall. Our expectations are for IMF involvement – but it will likely take a sharply weaker Euro before the Europeans are willing to make that call. This analysis fits nicely with the technical picture which indicates a short and sharp fall in the EURUSD. We expect that over the next few weeks as the EURUSD approaches 1.30 the calls for IMF aid will intensify. It is at this point that we shall begin to cover our short EURUSD position.

Disclosures: Short EURUSD, GBPUSD

Add comment March 23rd, 2010

One of These Things is Not Like the Other

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

Add comment February 8th, 2010

Antistrophe – A Period of Dollar Weakness?

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

Add comment February 2nd, 2010

A Picture of Health?

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

Add comment January 31st, 2010

Next Move for the Dollar Higher?

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

Add comment December 14th, 2009

Are Inflationary Pressures Building?

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

Add comment December 6th, 2009