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EconMatters - Global Economic and Market Analysis That Matters

Gold Becomes Inflation Hedge as Bond Markets Manipulated by Central Banks

June 19, 2014 by EconMatters   Comments (0)

By EconMatters  

Gold Break-Out Coming?
An interesting dynamic taking place in financial markets on Thursday as Gold saw some substantial buying interest up $22 to the $1295 an ounce area. It is obvious that inflation is picking up considerable steam as we just blew a 0.4% on the CPI Inflation Breathalyzer and believe it or not the 10-Year Yield is at 2.57% yield, welcome to mispriced and manipulated markets in the Central Bank manipulated markets era that we call free markets or bubbles galore.


Hot Philadelphia Fed Survey
At any rate since bonds are being bought and only sold when there is risk associated, i.e. Employment Reports, Fed Meetings, 10-Year Bond Auctions, Inflation Reports and as soon as those are finished the buying frenzy continues now that risk to their positions has subsided and they can load up on more free money chasing that Yield Carry Trade. 
However, look at the Philadelphia Fed Survey – hot on all accounts, for example the prices paid component was 35, this is an extremely hot reading so there is definitely hotter inflation in the economy than the Fed is willing to admit. The small business optimism metric is near record highs, and job creation is really percolating right now all fueling into the hotter inflation equation. 
Gold as an Inflation Hedge
Therefore Investors need some way to hedge their portfolios to this trending inflation concern, and since Bonds are massively manipulated they are desperate for inflation hedging vehicles and believe it or not it looks like Gold is starting to serve as this substitute for inflation hedging. Whereas investors were weary of using Gold due to its lack of Yield and the Central Banks raising rates; however since they are stalling on that front for the time being, maybe investors feel more comfortable using Gold for this inflation hedging purpose.
Gold Highly Manipulated Market
Gold has its own problems with manipulation, it was almost a daily occurrence that traders would make a small fortune smashing through stops every 7:30 am trading day like clockwork, and there are many other manipulative trading techniques utilized that require an entire article just on that subject alone! Financial markets really are as wild west as ever, and they will only get worse once the Central Bank Shenanigans come back to bite financial markets and volatility shoots off the charts! 
Danger Zone for Retail Investors
I would recommend that retail investors in equities move to cash right now, not bonds but actual cash! Sure retail investors will lose out to inflation eating away at their investment in real terms, but this is still a better outcome than losing one`s principle in addition to the nefarious hit of inflation on one`s principle. But the Federal Reserve and the Bank of England can only stall for so long in raising rates substantially from here, and given that many asset prices are artificially supported like equities and bonds through cheap liquidity, investors are potentially risking boatloads of principle trying to keep pace with inflation and the risk reward profile has a negative expected value over a substantial investment window. 
Gold is a Commodity - Commodities by Nature are a Highly Volatile Asset Class
However pay attention to Gold and see if this uptrend continues and the reason for any strength will be due to it being used as an inflation hedge, I don`t recommend retail investors using Gold via the futures market as an inflation hedge because there are just too many crosscurrents going on in Gold, and the Gold futures market is highly manipulated, and I will just leave it at that! 
Maybe place a small bet in the Gold ETF GLD, but don`t get carried away, actually purchasing physical Gold would be my preferred method for using Gold as an inflation hedge, but stay proportional to one`s overall investment allocation and do your due diligence on the best physical storage of value and vendor. 
Don`t go putting 35% of your investment funds in some Gold investment vehicle, it’s not the holy grail as some would have you to believe, it is a freaking commodity for goodness sake. And commodities are called commodities for a reason, and more investors have lost their shirts investing in commodities than bad beat poker stories. 
If one is a trader that is a different story, let the technicals be your guide to staying on the right side of the Gold trade. I will do a follow up later on the technicals in the Gold market, but for now this is just a heads up to what is potentially going on in the Gold market and worth paying closer attention to going forward.
Inflation Worries & Portfolio Hedging Instruments
But inflation is starting to bust out on investor`s worry list, and it is only going to get hotter for the remainder of the year, and some financial vehicle will be required to fill this inflation hedging purpose if the bond market being more manipulated than any other market by central banks fails to serve this role for investors who need to hedge the inflation risk in their portfolios.

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The Fed Just Lost Any Shred of Credibility on Inflation

June 19, 2014 by EconMatters   Comments (0)

By EconMatters  

Those High Chicken Prices are just Noise – Tell that to the Cashier
The Fed today in their press conference lost any credibility on a number of issues, and it really goes to show that they have no clue what they are doing at this point. First they called the overheating inflation in the economy Noise, yes you heard right NOISE which is now showing up even in the watered down indexes used to track it by the Fed, and already above their target of 2% on a year over year basis and rising, (wait until you see the next two month`s CPI reports on a spike in gasoline prices as we enter the summer driving season).


45% Appreciation is Normal Price Discovery & In-Line with Historical Norms
Then Janet Yellen says she sees no signs of a bubble in equity prices after a 35% appreciation followed by what looks like another 10% plus year of appreciation in the cards for 2014. It is one thing to be dovish, but when one goes out of their way to mischaracterize the data to such an extreme that it makes one lose any credibility just to justify a given monetary policy, that is when the proverbial shit hits the fan.
No Clue at this Point!
We would expect some major market vigilantism and volatility once the next hot Employment report comes in two weeks, and a scorching CPI Report hits the tape in four weeks that only reinforces the fact that the Federal Reserve has no clue what they are doing at this point, and Janet Yellen is basically my Grandmother in charge of the Federal Reserve. 
Frankly, that is doing a major disservice to my grandmother who could spot inflation when she sees it, there is no hope right now after hearing Janet Yellen speak in the press conference, she is completely incompetent and the exact worse person for what we are now entering in the inflation era!
Managing Market Expectations
I tried to give her the benefit of the doubt, that she is just trying to talk down the market to keep rates low for as long as possible, and maybe even the hot inflation data recedes a slight bit; but even with the strategy of dropping the tightening monetary bomb all at once versus slowly raising market expectations in an incremental fashion, she still will be setting markets up for a huge disastrous exit event the longer she prolongs the inevitable. 
But after listening to her talk in the press conference I am not even sure she is a qualified economist, moreover it is apparent she has no formal timeline for unwinding, and she cannot even properly understand basic economic relationships that any first year econ major has down after mid-terms! 
Go back and look at the inflation data and explain to me why this is not an upward trend for 2014, and an unsettling trend given GDP was actually negative for the first quarter, what happens to inflation when GDP prints a 4 handle later this year? What happens to inflation when the strongest part of the year from a consumption and GDP standpoint comes gushing into the CPI Reports? Janet Yellen didn`t think that UPS and Fed-Ex recently raising their pricing policy to now cover size of packages from a volume standpoint versus strictly weight had anything to do with inflation? Guess when these price increases are going to push through into the economic data sets - a clue - future PPI & CPI Inflation reports! 
If you have analysts who track these types of pricing pressures, and you can run forward models, why set yourself up to fail miserably in the future – it’s called managing expectations! She really has set herself up to fail by stubbornly refusing to acknowledge even near-term inflation levels, let alone future inflation pressures that will be much higher than her targeted forecast! These are basic corporate level CEO skills that any competent person in a management role understands, and it is unsettling that she doesn`t get this basic concept, and is managing the most powerful corporate board in the world!
Yellen`s Shelf-Life 2 Years
She has got to be the most dovish Fed chairperson in the history of the institution going into the most important policy initiative withdrawal phase ever to be recorded since the inception of the Federal Reserve! 
She will probably step down in a year at this rate, as she obviously was the wrong person for the job! President Obama should have chosen Larry Summers for the position, and now this is really going to cause the entire monetary experiment to blow up, it is looking more and more like a foregone conclusion. 
We are now going to have to resurrect Paul Volcker`s spirit to the Federal Reserve to dig us out this hyperinflation mess, once inflation I mean Noise gets so unbearable that Janet Yellen is forced to embarrassingly resign by the president as the bond market takes matters into its own hands!
35% Probability of Hyperinflation Cycle
With her increasingly dovish incompetence being on full display for market participants instead of the US merely entering an elevated inflation period, we now realize that Janet Yellen and the Federal Reserve are so behind the inflation curve, and many other market implication curves, that we probably are staring at a 35% chance of a Hyper-Inflationary period by the time the Federal Reserve realizes that Noise is actually real inflation!
Setting Herself Up to Look Even More Out of Touch with Reality
The surprising thing is that she backed herself into a corner on the data, and I expect the inflation and employment data to keep coming in much hotter and well ahead of the Fed`s own forecasts, and she didn`t even leave herself any real wiggle room. With each new data point she and the Fed are going to look increasingly out of touch and well behind the curve that it is going to be shockingly laughable. If they sky is cloudy grey, and you keep saying that the sky is clear blue, people are going to stop listening to what you have to say, it’s called losing credibility, and the entire institution needs all the credibility they can muster at this most difficult time – the unwinding phase! 
Loss of Credibility Worse than Actual Policy Decisions at this Crucial Monetary Pivot Point
The loss of credibility is by far worse than the actual policy decisions at this point, and after listening to Janet Yellen`s press conference, I am not sure she is a rational, logical, empirical thinking human being with her ridiculous comments regarding the stock market and inflation as she seems borderline senescent and incapable at best, and there is no doubt she is completely over her head at the Fed in this powerful position. I cannot wait to hear the Fed minutes of this latest Fed Meeting!
Markets will Dictate Policy for the Fed!
There is no hope for an elegant exit now from this monetary experiment, inflation will be at 4.5% before they even start raising rates! The bond market will be so far ahead of the Federal Reserve in terms of bond vigilantism that they are what will bring the Fed to finally realize that they have lost control of financial markets, and then it is endgame for interest rates! 
Once the bond vigilantes take control of markets because they have no faith in the Federal Reserve, it is time to seriously reevaluate what the makeup and role the Federal Reserve should play in future monetary decisions going forward! 
At this point we need a major overhaul regarding the powers of the Federal Reserve, if after the last Fed inspired bubble, where everybody made a note of the responsibility of not creating future “bubbly conditions” and with what I would called unsustainable artificial prices in many asset classes, it is obvious that the institution has no proper checks and balances and needs a major constitutional overhaul! 

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Every Middle East Flare Up Last Five Years Overblown By Media

June 18, 2014 by EconMatters   Comments (0)

By EconMatters  

The Latest Conflagration 
The Middle East has flared up again and as usual the media hype machine goes into full court press hyping the news event in desperation to boost ratings and sell advertising space. This is a slow time relatively speaking in the world, and now that CNN has beaten the Missing Malaysia Airlines flight MH370 story into the ground, they need something to fill their vapid programming void.


The stock market and financial markets are pretty somnolent lately as well, most days in the financial news world are pretty slow, so they are also desperate to hype any possible news event way out of proportion to bolster sluggish ratings.
This latest event out of Iraq is no different at this point, and chances are this latest Middle East flare up fails to go anywhere and live up to the hype in causing any major supply disruptions in Oil, a Geo-Political Shakeup that changes the game in the Middle East, or has any meaningful impact for the developed world and financial markets long-term. 
Middle East & Constant Churning of Chaos 
Let us revisit history, remember the Arab Spring? The next question is which iteration of the Arab Spring as there has been about three iterations in Egypt alone all of which haven`t really changed anything, or amounted to anything other than power transferring from one powerful group that doesn`t exactly have its citizens` best interests at heart to another powerful group with the same modus operandi. The more things change in the Middle East the more they stay the same. It sounds like a nonsensical statement, but that is the Middle East constant chaos and change with little progress towards enlightened goals. These events in the end are ultimately power grabs, and while the developed world has elections; the Middle East has ‘revolutions’. 
Media Attention Not Exactly Good For Small Insurgent Groups
Frankly I think 15 navy seals on the ground in Iraq with some strategically placed air strikes wipes the entire 2000 member ISIS militia off the face of the earth, and this problem becomes another short lived footnote for history books in the region. Use a little common sense folks, this isn`t a 9 Magnitude Earthquake hitting Los Angeles, this ISIS group wasn`t even on the radar a week ago, and with decisive military action their 15 minutes will last a month or less. This band of highly trained precision military killers is driving around in pickup trucks for goodness sake!
Actually, from their perspective the worst thing that could have happened to them was to get this kind of media attention because the Iraqi track team ran like a bunch of schoolgirls at a Justin Bieber concert. Now they have the world`s undivided attention, not such a good thing for such a relatively small organization that relies heavily on catching opponents off guard. 
Sun Tzu's Art of War applies here, if your enemy is stronger, the last thing one wants to do is get their attention and take you seriously as a potential threat until you are strong enough to fight and do serious damage in battle. This little insurgency group called the ISIS worst nightmare was having CNN cover their exploits, now we have large scale security meetings at the Whitehouse planning their demise – not exactly sneaking up on anybody from this point forward. This group needed to take Baghdad before they decided to celebrate and parade around, now they have the world`s undivided attention, and making any inroads towards the oil fields or Baghdad just became much more difficult by a factor of ten.
Market Implications & Taking Advantage of Media Hype in Both Directions for Oil Markets
This all has market implications and there has been a lot of money made by being patient waiting for the events to play out, and then coming in and shorting the Oil Markets the last five years. There are several dynamics in the Oil markets that make these plays especially enticing for trade setups. We aren`t going to do all the work for investors, put the time in and ask yourself what dynamics could EconMatters possibly be alluding to that makes Oil as a financial and consumer driven commodity different than say Equities, Gold, Silver or Bonds? 
Some of the tools required for navigating these events are patience, level-headed critical thinking abilities to analyze real threats from paper threats, and the wisdom to use stops if by chance this Middle East event does take a dynamic twist, and let`s say the Saudi Kingdom is overthrown and the Oil fields are set on fire – now that`s a game changing event. 
However, if the Saudi Government is strictly overthrown and the Oil fields remain in tack, while prices will spike a whole lot initially, that represents a market opportunity both on the way up, and the eventual inevitable collapse. Oil is a commodity that has value on the World Stage, but the other truism is that even Insurgents need money to flourish! Another truism is that as Oil prices spike, economics dictates that demand drops to the degree and duration that prices remain elevated, i.e., there`s no cure for high prices, like high prices! One gets paid in financial markets on getting the timing right, but in my experience 75% of investors cannot even get the analysis right in financial markets, and who can really blame them with the less than critical analysis that takes place in mainstream media.

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The Inflation Era Has Arrived!

June 17, 2014 by EconMatters   Comments (0)

By EconMatters  

IMF – Inflation Pressures Non-Existent
The Federal Reserve isn`t the only one, everyone from the IMF, Bond Funds, Wall Street Analysts, Hedge Funds and the Big Banks are on the wrong side of the market both in terms of inflation already in the economy, current inflation expectations and being properly positioned or hedged for the inflation trade.


The Wolf has Arrived, but investors ignored the Inflation Data
We have tried to warn market participants even three weeks ago laying out what would happen to the CPI Data, and based upon many of the responses to our warning; the complacency on this issue regarding inflation is off the charts. The entire world is asleep at the wheel regarding bubbling inflation, when the stock market keeps putting in higher highs after a 35% year that should have been a warning sign that there is way too much liquidity in the system. 
We noted that normally the market would go down on QE tapering, and the opposite caught many hedge funds off guard who tried to seasonally short the market in late April, and it is apparent that runaway inflation in terms of excess liquidity in the system is what is pushing the stock market higher. 
Above Trend Growth Equals Above Trend Inflation
But that is financial system inflation, we point to the stock market because that was a clue regarding inflation in the real economy that was well above what the trend had been the past 7 years. However, the PPI & CPI Reports for the last 4 months captured the above trend spike in inflation as well as the Employment Reports. Jan Hatzius, Goldman Sachs chief economist, says he believes the economy is now growing at an above-trend pace. Goldman's own current activity indicator is showing its fastest growth since the crisis, according to Hatzius. Well, we really shouldn`t be surprised that above trend growth brings above trend inflation pressures into the economy.
It is obvious that everyone from the central banks to the yield chasing carry traders would want to discount inflation concerns in order to keep the proverbial party rolling along in terms of monetizing the debt at ridiculously low levels, and borrowing free money for eternity. But for every action there is a reaction, and it was only a matter of when and not if, that market forces, in this case higher inflation, would react to such an excessively loose monetary policy experiment.
The Massive Unwind & Fund Flows
Now that inflation is here the massive unwind will begin in anything from bonds, currencies used to initiate this yield carry trade, gold and silver, stocks and fund flows around the globe. There are a lot of crosswinds with markets like Gold, does it go up on inflation concerns and investors no longer chasing yield, or does it go down on rising interest rates and a strengthening dollar? This goes for stocks as well, do they continue to go up on inflation concerns and outflows out of the bond markets, or do they re-price on deleveraging of carry trades and raising rates for borrowing money?
Sell Anything with a B in it!
The no-brainer is bond yields they are going up considerably from current levels, maybe slowly at first, but this slow upward trend will be punctuated by 10 and 15 basis point jumps in yields as resistance levels get taken out, and investors are forced out of positions that they fell entirely too much in love with regarding bonds in the era of easy money. 
Key Technical Levels for the 10-Year Bond Yield
In the 10-Year we jumped from 2.59% to 2.65% today which is near the next resistance level which is 2.67% in yield. This is the key resistance level to watch in the 10-Year, once we break through this level 2.75% is the next major level of resistance. There is some resistance at 2.70% but this is a minor stop on the way to 2.75%. Once 2.75% is breached, the next resistance level on the 10 Year is 2.80%; this is the final barrier to hold before 3%. If 2.80% fails it is a straight shot to 3%, 2.80% is the last chance for any of the non-believers to get out before staring down a 3% yield in the 10-Year. 
Once we break through 3% then 3.15% to 3.25% is the next area to watch, a breakout of 3.25% means 3.5% is a strong certainty as this yield train will be rolling. Investors probably cannot wrap their minds around how poorly positioned the market is for this change in yields, we could hit 4% on the 10-Year even before Fed Rate Rises justify such a move, just on a market squeeze and overshoot alone, maybe even 4.5% is possible given that the current market positioning on the wrong side of this trade is just that massive!
A Big Forest of Historical Knowledge
It is human nature to extrapolate recent history and postulate this trend going forward, or in other words to think entirely far too micro in terms of missing the big picture and lessons of history. Ben Bernanke has been extremely guilty of this with his “Not in his lifetime thinking” in terms of normalized rates. 
Fundamental Laws of Nature Always Prevail in the End
At any rate, Interest Rates are going higher, whether people and investors like it or not, it is how markets work, even highly manipulated markets, because there are bigger fundamental truths that eventually play out called “Unintended Consequences”, and you can ignore them and even downplay them for a while, but eventually and as sure as the fundamental law of nature that everything has a cost, they make their presence known, and demand Center Stage, the Inflation Era has arrived! 

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Bond Kings to be Dethroned in Second Half of the Year

June 15, 2014 by EconMatters   Comments (0)

By EconMatters  


Jeffrey Gundlach`s Outlook
Jeffrey Gundlach of DoubleLine Capital LP says the 10-year U.S. Treasury note will likely trade in a range between 2.20 and 2.80 percent during the second half of year. Gundlach also said U.S. Treasuries are a buy for investors as they are yielding in the upper half of his projected trading range. He said this on June 10th of 2014 and it seems he still expects the 10-year yield to be lower than the 2.40% bottom put in about 3 weeks and 20 basis points ago. 


He runs primarily a bond fund, and he gets paid mainly on assets under management, so talking one`s book to encourage more inflows into the fund is very important for his business model. Therefore it is hard to know whether this is just ‘sales tactical speak’ or he legitimately believes that the 10-year hasn`t put in the bottom for not only this year but maybe for the next five to ten years and beyond as many on Wall Street believe. 
George Clooney Doesn`t Need to Take Profits
However, if he generally is drinking the Bond Kool-Aid, and who can blame him with all the craziness of central bank intervention, that means he didn`t take profits when many did at the 2.40% lows, as the same day yields were back at 2.47%, a 7 basis point move, and quickly moved another 25 basis points higher before settling back at the 2.60% level. If I were an investor in his fund I sure would have wanted him to take profits there ahead of another robust jobs report, a Fed meeting announcing continued tapering and maybe more tightening, and strong GDP numbers for the second quarter coming soon.
Bond King Knows Best versus Most Jobs Created Since 1999
But again Jeffrey Gundlach specializes in bonds so I am sure he knows best, but I would give him a friendly wager that the 10-year yield is higher than 2.80% over the next 6 months as our economy seems to be back-end predisposed to growth within a given year based upon everything from back-to-school retail spending, holiday supply chain drivers and football season.
I believe Gundlach is focusing too much on European Bonds relativity to US Bonds, and as Bank of England Governor Mark Carney said last Thursday U.K. interest rates could rise sooner than investors expect. This goes the same for US investors as the Fed could be forced to raise rates much sooner as Joseph LaVorgna, chief U.S. economist for Deutsche Bank recently put the robust job growth this year in context by pointing out that if we continue on this same pace of adding jobs to the economy more jobs will be created in 2014 than in any year since 1999.
Context for the Doom & Gloom Crowd
This is an amazing fact when you consider that anybody who could fog up a mirror was hired in the tech bubble running up to 2000. For all those who focus on the slow growth in the housing sector right now including Jeffrey Gundlach, remember that the jobs created this year are more than the 2003-2006 housing boom on an annual basis. 
What Jeffrey fails to realize is that our economy has shifted from a housing based economy to a technology based economy; we are far healthier in the technology industry than we ever were in the 2000 boom era in technology. 
This fact is lost on a guy whose fund is based in California which seems even more short-sighted in our opinion. Besides Apple, Facebook, and Google even Intel, Microsoft and HP are showing some life with new leadership changes. We are on pace to create more jobs in this country than the tech glory days, the housing boom years, and the mortgage underwriting boom on a year over year comparison, and Gundlach thinks rates are going to stay below 2.80% for the second half of the year with the Fed exiting the bond market?
Joseph LaVorgna - Deutsche Bank Economic Forecast
Frankly there is a big difference between Europe and Japan on one hand and England and the United States on the other, the latter will be raising rates sooner than investors currently have priced into their models as Joseph LaVorgna states so succinctly: “In six months, the unemployment rate will be below 6% and the core inflation rate will be at 2%,” he said. “We are way ahead of schedule. We’re going to get to 5.2% or 5.4% a year ahead of schedule.” And that the “The Fed is behind the proverbial curve,” and “The Fed should be raising rates.” 
Inflation Expectations to Rise in Europe
Frankly when it comes to Europe I think investors were just an example of the ‘inmates running the asylum’ who wanted a bunch of free money from the ECB, their inflation rate was still 0.5% by their measures and probably much higher in real terms. 
Markets influence the Central Banks these days, and they keep begging hard and long enough eventually they force these weak central bank official`s hands within limits and have gotten their free capital. However, I think just as the Fed was raising the Fed Fund`s rate to 5.5% right before the financial crisis, the ECB decision on rates and other monetary stimulus measures is the last we will see for a long while. 
To be more specific, we have reached the end of the easing monetary cycle with the recent ECB fait accompli and this sets the stage for the next tightening monetary cycle. This tightening monetary phase which is upon us and will have to run its cyclical course will be at least 5 years in duration in our opinion. The Central Banks will be forced to pivot to the tightening cycle in order to combat rising inflation pressures.
At any rate, I expect Europe will be raising their equivalent to the Fed Funds Rate which currently stands at 15 basis points in 9 months as they are more concerned with inflation levels than employment levels, and any uptick in measured European inflation freaks them out!
The Inflation Era
We think the inflation cycle is finally upon us even in official measurements that Central Banks focus on now that the wage part of the inflation puzzle is set to take off as witnessed by Seattle’s $15 minimum wage law recently enacted and these wage pressures start to push through to the rest of the country. 
Wages are finally going up in all areas, not just the upper spectrum of employment. We are officially in the wage inflation cycle, and tightening monetary policy is to follow as the Central Banks are forced to cut off the free money supply. It is now going to start costing investors to borrow money which is a healthy thing in our opinion.
Summary
In summary, we believe Jeffrey Gundlach is wrong regarding the 10-Year Bond yield staying below 2.80% over the second half of the year as growth picks up and accelerates during the home stretch of 2014. We believe the Fed will be forced to raise rates before March 2015. Just like the Bank of England Governor Mark Carney`s recent market warning, Janet Yellen will be sending her own market warning over the next six months that she needs to move faster on rate hikes.
But that`s what makes markets, for every buyer there is a seller! And we are definitely sellers of bonds at these levels. We believe that anything below 2.60% in yield on the 10-year over the next six months represents a positive expected value proposition from yield appreciation over this time period. 

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Wall Street Yield Trade: Another Explanation For Low Inflation

June 10, 2014 by EconMatters   Comments (0)

By EconMatters

In an unprecedented move to fight off the threat of deflation, ECB cut its main interest rate to near zero at 0.15%, and its interest rate on deposits to a negative 0.1% for the first time. This means ECB will now be charging banks 0.1% to hold their reserves.  ECB hopes these aggressive measures would spur banks to ramp up lending, and also weaken the euro. France has long been arguing that high euro exchange rate is holding back the economic recovery in the Euro Zone.

Testing Keynesian Theory

ECB and the U.S. Fed essentially have the similar Keynesian idea: Central Bank's act of reducing interest rates and increasing money supply would discourage savings, stimulate spending and demand for goods and services and improve bank balance sheets and banks’ capacity to lend.  This sounds nice in the context of Keynesian Economics; however, it has not worked quite that way in the U.S. despite Fed's massive money printing operation since 2008, an observation I'm sure Draghi 'overlooked' trying to repeat the proven ineffective steps of the Fed.

Deflation Anxiety

Conventional wisdom had many concerned about run-away inflation because of the $3.5-trillion injected by the Fed into the economy, but that did not really materialize.  In fact, up till the two most recent hot CPI and PPI reports, one major anxiety of the Fed was that the U.S. would fall into a prolonged Japanese-style deflation.

The Liquidity Trap?

Some economists believe the disinflation seen in the U.S. is mostly due to weak demand commonly seen during an economic recovery.  A blog published in April by the St. Louis Fed noted that as money supply (M0) increased 40.29% between December 2008 and December 2013, or about 8% per year on average, inflation should run at a pace of 4.3% per year.  But this did not happen.  St. Louis Fed posits that the liquidity trap could be an "alternative explanation for the generally unanticipated disinflation or low inflation levels".

Liquidity trap is a situation characterized by interest rates that are close to zero and fluctuations in the money supply that fail to translate into fluctuations in price levels.  One cause of the liquidity trap is cash hoarding because people expect a crisis event such as war or market crash.  As St. Louis Fed describes it:

During a liquidity trap...., increases in money supply are fully absorbed by excess demand for money (liquidity)....if money demand increases more than proportionally to the change in money supply due to the downward pressure LSAPs [Large Scale Asset Purchases] exert on the interest rate, the price level must fall to absorb the difference between the supply and demand of money.

Flight to Cash

As we can see in the chart below, Personal Savings Rate jumped up during the post-crisis recession period, and has remained higher than pre-crisis levels ever since.  In addition to consumers, American companies are also building up liquidity and holding onto record $5 trillion in cash.  This seems to support St. Louis Fed's position that low interest rate may have induced the flight to cash thus increasing the demand for money.

Wall Street Yield Trade

In our view, another major factor to the slow growth/low inflation in the U.S. is that Fed's ultra low near-zero interest rate actually incentivizes the Wall Street Yield Trade -- using the free money from the Fed to buy up Treasury for a risk-free profit delta bidding up Treasury prices while pushing down Yield.  As the bond market gets more crowded, some banks would use that money to buy up the stock or commodities such as crude oil or agricultures for a much better risk/reward return than mere lending to business and consumers.

Low Interest Rate Is Deflationary

In other words, by incentivizing unproductive use of capital, low interest rate is deflationary.  The majority of Fed's QE liquidity ended up in personal or corporation cash holding, or in the market (Treasury, Bond, Stocks, Commodities) without trickling down to the real economy leading to slow growth and disinflation (U.S. consumer inflation averaged around 1.6% per year from 2009 to 2013 in terms of CPI-All Urban Consumers).

European Bond Holders Could Take A Nasty Fall

In the case of the Euro Zone, low interest rate by ECB may have helped those semi-insolvent PIIGS governments to refinance their insane levels of debt.  Nevertheless, bond yield is supposed to be a risk measure.  After ECB announced its new low interest rate, the Wall Street Yield Trade has rendered the yield of some Euro Zone government bond a total mis-representation of the related sovereign risk.  For example, while U.S. 10-year Treasury yield is hovering around 2.6%, Spanish government can now borrow at 2.57%, a rate lower than Uncle Sam.  Equally ridiculous is that Italy now only pays 2.70% (or 0.1% above the U.S.) interest for its debt.

Everybody loves a risk free trade, but this is not a normal situation.  Once interest rate starts to normalize. the bondholders of the more risky Euro Zone government debt could see a rapid and nasty devaluation of their holdings.

Inflation Heating Up


The most recent reports on jobs, CPI, and PPI all suggest U.S. economy is picking up solid pace. And the chart above also shows a downward shift of Personal Savings Rate.  Savings Rate is trending down most likely due to better jobs market and inflationary pressure on everyday stuff (e.g., food and energy).  Inflation is indeed heating up -- the average annualized inflation rate for 2014 (Jan. through Apr.) is around 5%, while the same inflation trend from the Producer Price Index (PPI) is well above 5%.

The Right Move: Raise Interest Rate

Most central bankers are academics in the ivory tower making decisions based on economic theory that defies reality or common sense.  But in its blog post, the St. Louis Fed actually made a logical argument:

....more monetary injections during a liquidity trap can only reinforce the liquidity trap by keeping the inflation rate low (or the real return to money high). ....the correct monetary policy during a liquidity trap is not to further increase money supply or reduce the interest rate but to raise inflation expectations by raising the nominal interest rate.

With both inflation and economic activity ramping up, we also believe that the Federal Reserve should raise interest rate to get ahead of the inflation curve and also to push the liquidity out of the 'risk free' Yield Trade, into more productive economic and business activity.    

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Doom & Gloom Sells

June 7, 2014 by EconMatters   Comments (0)

By EconMatters


Improving Economic Data
We have noticed that despite an improvement in the economic fundamentals of the United States as per the robust manufacturing numbers, automobile sales data, and upbeat employment numbers in 2014 many go out of their way to find negatives in every economic report instead of focusing on the relativeness of the data. In other words, are we doing better in these areas than two years ago on an “apples to apples comparison” basis?


‘Relative Improvement’ versus ‘Relative Perfection’
Sure there are things in most economic reports that could be better in an ideal world, and this world is far from ideal, and is coming back from a tough period after a structurally significant deleveraging process due to the cyclical natures of economies and business. 
But to just pick apart negative aspects of a good econ report because growth isn`t as fast as it could be, or employment isn`t perfect compared to the 1950`s boom is shortsighted and misses the real point of these reports, which is to show the trend in relation to the past six years. The relative improvement in the data over an annual basis compared to the previous three years, two years, and a year ago levels. Is the trend still in place, what is this trend, has a new trend emerged? This is what we are looking for in the data comparisons, and not whether the econ reports are ‘perfect’!
For instance take the employment reports, we just had the fourth straight 200k plus Employment Report, a trend we haven`t had since the year 2000, yes 14 years, and in even good and bad economic cycles, and people could point to the level of participation as their sole focus if so inclined. 
I think there are many structural issues behind the participation rate that are much more complex than the simplistic view that there are simply not enough good paying jobs so these workers have given up hope. But regardless, first we have to employ the individuals who are in the job market, and we are doing a pretty damn good job of that right now “relatively speaking” to two years ago when 80k was the norm, remember it is all about ‘relative improvement’, and not ‘relative perfection’ in the data.
Negativism & Cultural Influence 
However, I think this cynical enduring pessimism goes far beyond economic reports, and is really a reflection of culture spawned through the modern news media and online dialogue that is message boards, blogs and social & political commentary. 
It just has been hip, financially beneficial and downright uncreatively easy to take the negative angle regarding any subject for the last decade. Now I am not saying that one should ignore reality at all costs, read Dr. Norman Vincent Peale`s The Power of Positive Thinking, and think everything is rosy in the world that we live in. But by the same token it seems equally, and even less beneficial in some respects to always look real hard for negatives at the expense of acknowledging the complete picture in any thorough going analysis. 
For instance, these are strengths in the report, these are the weaknesses of the report, but overall the big picture is telling us that this is a good economic report. Versus the trend today is too ignore anything good in an economic report, find a negative, push this angle for all it`s worth, and celebrate one`s ‘critical thinking’ abilities, and maybe even make a name for oneself in the all-important media landscape.
Negative Behavioralism
In short, one can always look hard enough and point out some kind of negative, because as negatives go, they often are the result of necessary tradeoffs for the positives in this world, even in highly productive and efficient operating systems. 
It isn`t lost the fact that people seem to like to hear negative stuff, they seem to revel in it at times, it sure seems to sell by the news produced in this country for the last 50 years, it almost provides entertainment drama that somehow is lacking in people`s daily lives. 
However, the evolutionary goal for humans is to best understand how their environment is actually functioning, in order to better adapt to this environment, or change this environment where possible, and improve quality of life as a species and civilization. 
So you’re a rebel, a real devil`s advocate, go against the grain for the sake of going against the grain type individual, yep you found the negative, good for you! But is your analysis the best approximation for what is going on in the world, or has it become second nature to always see the negative in everything that you analyze from a behavioral standpoint? 
Have you become conditioned to always see the negative at the expense of missing the bigger picture? By focusing solely on the negative, is your world view the best explanation for what is actually occurring in the world? Has your ‘Negativeness’ become reflexive and ‘lazy intellectualism’? 
Five Consecutive 200k Employment Reports 
I don`t know about you but I will sure cheer another 200k plus employment report hitting the wire next month, things are looking up in the economy, and better times are ahead for many Americans! Society and the world is going to move forward, with or without you; it overcomes setbacks and strives to make improvements in progress towards greater goals. Unremittingly stuck in ‘Negative Land’ may be socially chic, but it sure doesn`t capture what is the essence of human creativity and innovation, and it sure limits possibilities.

 

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China-Vietnam Conflict in The South China Sea

June 5, 2014 by EconMatters   Comments (0)

By EconMatters

China is on a roll upsetting neighbors from all directions in its aggressive stance towards territorial claims. 

East China Sea


In the East China Sea, tension and hostility from the row with Japan over a group of uninhabited islands, (known as Diaoyu in China, Senkaku in Japan, Diaoyutai in Taiwan) has dialed up:         
  • Last November, China created a new air-defense identification zone to include Diaoyu, and would require any aircraft in the zone to comply with rules set by Beijing. 
  • In May 2014, Tokyo reportedly is planning to set up 3 military outposts near the islands to boost Japan’s defense of ‘its outlying islands’.   
  • A close call to blows about two weeks ago when China scrambled four fighter jets to deter Japanese aircrafts in the disputed water where China just carried out joint maritime exercises with Russia.  
South China Sea

Tension has been rising in the South China Sea since May 1 after China’s state oil company CNOOC mobilized a deepwater semi-sub rig HD-981 drilling near the Paracel Islands (known to China and Taiwan as the Xisha Islands), close to the Vietnam coastline and also claimed by Vietnam.  In response, Vietnam dispatched some 40-vessel coast guard fleet to the rig location, but only to be outgunned and outnumbered by China’s fleet of some 60 vessels (including Navy warships, and fishing boats) and fighter jets escorting the $1-billion rig.  According to Vietnam, China has since upped the fleet around the rig to 90 vessels    
       
That big oil rig has sparked anti-China protests and riots in Vietnam.  China had to send ships to evacuate Chinese workers after some Chinese nationals were killed, and 400+ Chinese factories were burnt down during the riot.
Reportedly, China Oilfield Services Ltd., a unit of CNOOC operating the deep-water rig, already mobilized the rig last week about 20 nautical miles to the east, but drilling exploration was expected to continue until mid-August.  Hanoi said the rig still remains in Vietnam's exclusive economic zone as defined by the United Nations.  While the rig is still sitting right in Hanoi’s face, the latest drama came this Tuesday after the two navies almost came to blows beyond water cannons.  
Separately, China is also has disputes with the Philippines which claims part of the Spratly Islands in the region.  Malaysia, Brunei and Taiwan all claiming parts of the South China Sea are also rejecting China’s claim. 
China ‘9-dash Line’ for Decades

Citing 2,000 years of history where the Paracel (and Spratly island chains) were regarded as integral parts of the Chinese nation, China has for decades claimed a U-shaped ‘9-dash line’ of the South China Sea (see graph below).  This is nothing new and has long been disputed and protested by the neighboring countries including Vietnam, Philippines, Malaysia, and Brunei.  (Taiwan, which considers itself the only legitimate democraticgovernment of China, has a similar claim to Beijing’s.) 
Map Source: WSJ
Potential Rich Oil and Gas Deposits

Everything got much more intense after it was discovered that the South China Sea (as well as the East China Sea) could have rich oil and gas deposits.  This is part of the reason for the U.S. involvement and energy-hungry China flexing its new and improved maritime and economic muscle to assert and defend its claims and sovereign rights as perceived by Beijing.   
U.S. Butting In 

The U.S. even though officially indicated not taking a position on these territorial disputes, but as Obama re-pivots to Asia to counter-balance China’s increasing influence in the region, countries like Vietnam, Philippines and Japan are looking to the U.S. to essentially back them up when push comes to shove going against China. 
To put it another way, when you look at the map comparing the size of Vietnam or even Japan, for example, to China, before even taking into account the respective GDP size, trade volume and relations, what do you think has bolstered the ‘confidence’ of Vietnam and Japan to confront China in such assertive manner, including allowing the anti-China riot to take place?  Remember, Vietnam is a communist country similar to China in that public demonstration does not ever occur without official sanctions.  The same behind-the-scene U.S. support is also evident in the case of the China-Japan island row in the East China Sea
China, Vietnam, Philippines in International Mediation

Vietnam is now preparing to sue China in an international court, while the Philippines say it will take China to a UN tribunal.   Nevertheless, experts believe the attempts by Philippines and Vietnam to pursue China via international mediation would be futile as China would not be obliged to abide by the ruling.    
U.S. Re-pivoting China To Russia

With the U.S. eager to demonstrate goodwill gesture and support to the region, the re-pivoting to Asia campaign by the U.S. is actually re-pivoting China towards Russia.  China and Russia just completed a joint naval exercise last month where both Putin and Xi Jinping attended the opening ceremony.  According to Taiwan media, as part of the exercise, China and Russia exchanged closely-guarded military and communication system intelligence which signals an unprecedented level of cooperation between the two.  Furthermore, in exchange for signing the $400Bn and 30-year gas deal, China will be gaining some much needed invaluable top military technology know-how’s from Russia.        
   
China Calling Obama’s Bluff

Territorial disputes (land or sea) among Asian countries are as old as history itself.  Countries usually worked things out eventually or keep status quo.  The situation in the East and South China Sea would not have escalated to the current state without U.S. trying to play all sides. 
China is basically calling Obama’s bluff that the U.S. will not be able to walk the talk.  Frankly, it’d be very imprudent of U.S. to really go against China by taking side in these regional squabbles and  risks China and Russia re-acquainting into BFFs again.  
CNOOC Chairman Wang Yilin once said, 

"Large-scale deep-water rigs are our mobile national territory and a strategic weapon".  

So China is unlikely to show weakness losing face in front of the international community, while it is too late in the game for Vietnam or even the U.S. to back out of the situation, even if they want to. Since Vietnam spent $714 million last year on Russian military kit, it’d also be interesting to see Russia’s reaction to the new ties between Vietnam and U.S. 

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Major Economic & Central Bank Events on Horizon

May 30, 2014 by EconMatters   Comments (0)

By EconMatters  

Since the last Employment report things have been relatively quiet on the economic and Central Bank front but all that is set to change over the next three weeks. Volatility should pick up and many of these events could be potentially market moving for certain asset classes.


Week One Events
On Monday June 2nd we have some construction and manufacturing economic reports, and these have been coming in slightly ahead of expectations. However, on Wednesday the ADP Employment Report will be a precursor at least in theory to the Friday Employment Report, and traders often position themselves based upon the outlook provided by ADP. 
Thursday, June 5th will be dominated by the ECB Meeting and what Mario Draghi`s actual stimulus announcement is and this has been much telegraphed to the markets, but no real fine details seem to be known for sure by markets. There has been a lot of positioning prior to the event that markets could react in a myriad of ways to the announcement. Is it fully priced in, is it more groundbreaking than markets expected, a disappointment, sell the news event? This is hard to call but my best intuition is that far too much positioning went on in bonds in Europe before the event, and I expect they sell off in reaction to the news.
On Friday is the big employment report for the US, a high frequency and co-location`s wet dream as they are guaranteed to make money by speed alone on any news. We expect another 200k plus report but the doom and gloom crowd will look for any weakness in the report to justify their positions on the market, so some of the inner workings of the report might be more relevant for this crowd. If we see improvement in the labor participation metric or wages these might be more important for bulls than the headline number and the unemployment rate. Of course the Algos immediately trade on the headline number, but the staying power of any directional moves comes from the complete report with its underlying metrics.
Week Two Events
The following week gives traders a couple of days to digest two really big market moving events, and some repositioning might occur in portfolios. On Wednesday, June 11th the 10-Year Note Auction occurs in the middle of the day and this is going to be an especially important auction given where rates are in relation to the previous week’s news. This is followed by Retail Sales and Jobless Claims numbers on Thursday June 12th; and on Friday PPI comes out and this is important given some of the higher than expected inflation numbers of late in other economic data. Again I think this week will have a pivotal impact on the bond market depending upon where technical levels are in relation to hotter or colder data results in these reports.
Week Three Events
The following week on Monday June 16th has the Empire State Manufacturing Survey with Industrial Production and the Housing Market Index, more Econ news than usual for a Monday. On Tuesday June 17ththere is the CPI and Housing Starts data that hits the wire as the FOMC Meeting begins. A hot CPI the day the Fed meets should have more impact given the recent hotter CPI reports, maybe even getting mentioned in the Fed Statement the following day. On Wednesday June 18th the FOMC Meeting Announcement is followed by the FOMC Forecasts and Chair Press Conference with many potential market moving messages coming out of those three events. 
Inextricably Linked Events
The interesting part is how the Econ Data and Central Bank events for the next three weeks all directly affect the next event, and how the market digests all these events as a whole. A couple of hot PPI & CPI Reports for instance affects the way the FOMC message is tailored, a strong Employment Report and better than expected Retail & Vehicle Sales may convince the doom and gloom crowd to reposition some of their portfolios relative to economic growth. 
Summer Boredom Breakouts
I would expect volatility to pick up and markets to move on many of these events, and after several weeks of relative ‘snooze fest’ things should get quite interesting for financial markets, and certain asset classes and portfolio rebalancing towards the end of the quarter might need more than a little fine tuning.

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The Party Is Over In The Treasury Market

May 30, 2014 by EconMatters   Comments (0)

By EconMatters


Last Hurrah
Everybody knew the GDP number was going to be revised down on this reading, and that it probably gets revised up for the next reading, and Bond Traders used the Revision in first quarter GDP to take the 10-Year Yield down to 2.4% on a nice push, but this required a whole lot of ammunition, and as soon as Europe started to close at 10 am central time (Europe close is 10:30 am for practical purposes) the Traders needed to start closing some of these positions.


Bottom in the Bond Market
The 10-Year then went 7 basis points higher to actually end the day up, which in trader`s terms is an outside reversal, or a very bullish sign for 10-year yields going forward, this effectively is the bottom for the 10-year bond yield for 2014, 2015, 2016 and beyond. 
Mark this date in your calendars as the last time the 10-year Yield was this low, we mentioned in an earlier article about this market being a coiled spring, well just sit back and watch the carnage as everyone tries to run for the exits at the same time in the bond market. Grab some popcorn because this is going to be funny over the coming months and years as yields continue to rise, some poor sap actually bought a 10-Year Bond today at 2.41% Yield, and thought this was a good investment.
Stop Trading on 3 Month Old Data
Bonds should have never gotten this low, everyone and their mother is underestimating inflation going forward, and the idiots on the Federal Reserve are so behind the curve, still talking about data 3 months old. By the time they realize we not only have food and energy inflation, but that wage inflation is coming in the next three months if not sooner, the absolute wrong-footed Federal Reserve & Bond Market are in for the shock of their lifetimes.
Massive Outflows Coming in Bond Funds
Literally bond funds are going to see such outflows, there are going to be money managers and hedge funds going out of business on this chasing yield trade blowing up in their faces. Margin clerks will be tapping a bunch of folks on the shoulders the next 6 months and beyond on this massive unwind in bond markets. 
I have never seen a market where so much money, and the consensus view is so wrong on this trade; the unpreparedness, the fact that not only do these people Not have an Exit plan, they don`t even know they need one on this trade. 
This is like the housing market can never go down logic; that interest rates will never go to 4% in their lifetime unpreparedness. Remember the Fed Funds Rate was 5.5% right before the financial crisis in 2007, this is hardly a century ago, it occurred in the last 10 years.
Federal Reserve Members are Clueless
I used strong language when I called the Federal Reserve members idiots, but the more I hear these people talk about the economy, this includes Bernanke now that he is retired, I cannot believe these are the best and brightest economists that America has to offer, because they are totally clueless. Even the hawks on the Fed are behind the data curve by at least 3 months, inflation is here, they better start raising rates next week.
Equities Running on Inflation Power: Forget Valuations at this Stage
This is what the stock market is telling everyone, and I like everyone was waiting for a summer pullback, a bunch of Hedge Funds starting shorting the market in anticipation, going long bonds; but inflation cannot be held back once it takes hold, and equities are off to the races, there will be a short squeeze in equities going forward. 
Once people realize what is going on with the reality that this cheap money has finally reached escape velocity with nowhere to go, and bonds are no longer an option once the realization that inflation is going to force the Fed`s hands, all this money is going to finally rotate out of bonds and into equities. We could literally see 2500 in the S&P 500, while the Fed tries to soak up this excess liquidity in the financial system. 
I am not sure how it will play out in equities once Bond yields spike, but where does the money go? Does everyone just run to cash? There are two things I am solid on however, one is that bond yields are going to explode higher, and the other is that volatility is also going to go much higher, so who knows how this is all going to play out in the equity markets. Maybe bonds and stocks sell off together.
Yield Trade Pushed Down Volatility
The abundance of money chasing the yield trade has pushed down volatility, and as the yield trade unwinds there are going to be some volatility traders that go out of business as well. I just cannot fathom how so many investors and traders are currently poorly positioned for one of the biggest moves in markets coming down the pike since the tulip market collapse. 
Bond yields are in a bubble all over the planet, and first you have food and energy inflation, then you have wage inflation to pay for the rising food and energy costs due to the final piece of the puzzle in the tightening labor market. The US exported a bunch of inflation to emerging markets over the last five years, now it is our turn to experience inflation as a result of too much cheap money in the system. 
We are currently right at the tipping point of inflation, and nobody sees it at the Federal Reserve, why do you think there are all these minimum wage initiatives? It is because a loaf of bread costs $3-$5 dollars in the United States depending upon the market. Of course wage inflation is going to be the next shoe to drop! 
Talking about an Exit Strategy, Isn`t an Exit Strategy
I am sorry it is very apparent that not only is the Fed behind the inflation curve, they literally are making Fed policy up as they go along, they have no exit strategy whatsoever, and more painfully obvious is that Wall Street doesn`t realize that the Fed has no exit strategy. The learning curve is going to be painful as always for Bond Holders, who will be the last fool to own a bond in their portfolio? There will always be some Bag Holder in financial markets, and this time it is Bond Investors or should I say Yield Chasers!

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