Decoupling Discredited and Deflation
By Frank Barbera CMT. February 19, 2008
As we look ahead at the deteriorating financial landscape it is hard, if not impossible, to see what, if anything, could begin to arrest the brewing "perfect storm." Yes, we know the Fed has cut rates, and that lower rates will eventually equate to a positively sloped yield curve, which will help re-liquefy the banks. Yet, there are so many domino style pieces that seem irrevocably interconnected in today's global financial system that it is hard to see how the "daisy chain" of cascading debt defaults will be stopped and brought under control. Perhaps the most imminent threat comes from the monoline insurers, where rating agency downgrades seem poised to force at least another $150 Billion in write-downs on ABS portfolios for various financial institutions which already have massive losses. Of course, this week should be quite the tell, as last week New York State Governor Eliot Spitzer gave the monolines, AMBAC and MBIA just five days to come up with and devise their own rescue plan or else face a potential break up by the New York State Insurance regulator. As the week develops, there are several directions this unfolding drama can take, including a belated bank rescue, a take over by New York State, or ultimately, a Federal Bailout.
To date, odds seem to be fading rapidly for any hope of a bank-led rescue fund, as had been thought only a few weeks ago. Instead, banks are hoarding capital to shore up their sagging loan-loss reserves. At the same time, under Mr. Spitzer's proposal, if New York State takes over, the companies will see their healthy assets and damaged assets separated into individual companies. The thought along these lines would be to help shield the 2.6 Trillion dollar municipal bond market from being downgraded in tandem with the monolines. Because the monolines have been the big players in the muni-bond market, any downgrade of the monolines would automatically hurt the ratings of umpteen billions of values in muni-bonds. This would make it infinitely more difficult for State and Local governments to raise cash to help fund government projects, as without insurance, these bonds would trade at much higher yields.
However, the downside to Mr. Spitzer’s plan seems to be that in separating out the good from the bad assets, that those companies holding the bad assets would be, in all likelihood, nearly worthless. This could then force the major banks to realize even larger write-downs on assets in coming quarters exposing the broad financial system to the threat of a systemic banking shock. Another option which is also being discussed is that of a Federal Government take-over, wherein it would be hoped that the full faith and credit of the US Government would restore the bad credit of the monocline insurers. Unfortunately in this scenario, the exact opposite outcome would likely unfold with the bad credit of the financial sector dragging down the good faith in US government debt, which would likely see Bond yields rise.
At this point, domestic stated inflation ran at a 4.00% annualized rate in the fourth quarter of 2007, up a full 2% from the 3rd quarter. That means that with a current yield of 3.80%, the 10 Year Bond now has a negative inflation adjusted return. With the Fed injecting money into the system, and now fiscal policy poised to throw in another 150 Billion in bail out "cookies," we are not looking at a good recipe for bond yields staying low for very long. In the next chart below we show the US Dollar Index in the top clip illustrating the multi-year decline which began in 2002, while on the bottom clip we show the trend in US Bonds-Fixed Income graphing the Lehman Bond Index in both US Dollar terms (thin line) and as seen in foreign currency terms (bold line). How long will foreigners continue to recycle excess savings in US Treasuries if they are getting killed on both real after inflation adjusted returns, and on the currency?
Above: US Dollar top clip, and Lehman Bond Index lower clip as seen in US Dollar terms (thin line) and as seen through the eyes of foreign capital (bold line).
Above: 10 Year Bond Yields 1945 to present with Monthly MACD and Monthly 1 Year Bollinger Bands.
As we can see on the very long term chart of the 10 Year Bond Yield, the set up for a secular bottom in yields seems to be taking shape. In a classic bottom, the most common type of turn for a market is a "W" bottom formation, where prices spike down and make a panic low (the left side of the W), rally up for a period of time and make the middle of the W, and then come down a second time and retest the prior low forming the right side of the W. Inexorably, momentum indicators show a pronounced positive divergence (less downside momentum) as prices come down and retest the low to form the "right side" of the W. In the case of the 10 Year Bond yield, the panic "left side" low was seen back in September 2002 with a low yield of approximately 3.30%. At the time, monthly MACD bottomed at a ratio reading of .896. Since then, we have seen yields trend higher tagging the upper one year Bollinger Band in June 2006 with a yield of 5.25%, and now over the last few months, experiencing a dramatic sell off back down across the entire range of the last few years. In fact, on January 23rd, the 10 Year Bond yield actually dipped on an intra-day basis to an all time low reading of 3.28%. So far, MACD, while moving lower, is nowhere close to the .896 reading seen in Sept. 2002 with current values near .95. This means that all the potential ingredients are falling into place for a SECULAR (multi year) trend reversal in Bonds.
Turning to a closer in view, we see the daily chart for 10 Year Yields above. To begin with, we note that at the recent panic low (Point X), yields spiked down and outside the declining 100 day medium term band. This was a sign that the market was a roaring freight train on the downside with lots of downside momentum. Like an ocean liner, markets as large as the 10 Year Treasury take a lot of time in order to reverse the direction of the primary trend. So what's next for the 10 Year Bond? Chances are fairly high that in coming weeks we will see a peak in the 10 Year Treasury Bond near these levels and then a steady retest of the January 23rd low setting up what could be a final double bottom low on the daily chart.
While we know there are those who would argue that the Island Reversal low on the 23rd of January may have been the final low in Bond Yields, we would point to the downside slope of the 100 day, or 20 week moving average which is trending down at about a 45 degree down angle. Nine times out of ten, on the first assault this moving average is resistance, and only once it begins to flatten out are we closer to the point of a more serious trend change.
In our view, IF Bonds are recording the finishing touches on some type of secular low, chances are it will take until at least April - May, if not June before we see real evidence of a major turn. By then, the medium term declining tops line, which right now remains very much intact, will be down to the 3.60% to 3.70% level with any upside directional move above that trendline probably signaling a completed low. As a result, this means that a deflationary mindset will likely continue to grip markets for some number of weeks, as falling bond yields can be a sign that money and capital are seeking safety at all costs.
Later on, IF and WHEN Bond yields do begin to rise in a consistent fashion, the key elements will be to see if it is Dollar weakness that is forcing rates to the upside. So far, during 4 years of Dollar Bear market and even a break down to new all time lows, the weakness in the Dollar has had zero affect on long term yields. This may not remain this way indefinitely, as a slowing global economy will mean that foreign countries will have fewer Dollars in their current account to recycle into US Bonds.
The multi-year Chinese practice of mercantilism and vendor finance could soon be coming to an end. When it does, the US will see inflation return as the chief culprit, as not only are commodity prices already sky high throughout the world, but when U.S. Dollar recycling comes to an end, prices at Wal-Mart and Costco will start to move inexorably higher. As we see it, this is a "one-two" punch of "recession/stagflation" followed by "reinflation/runaway inflation" which could get out of hand if foreign capital abandons the greenback. Yet, while the US does have a huge number of serious financial problems, it is also worth pointing out that the recent period of a super strong Euro is also taking its financial toll on European growth. Just recently, Bernard Connolly, global strategist at Banque AIG, stated that "euro-losses may surpass the US, with the next really big shock to financial markets, likely to be the risk of collapse in the EMU credit bubble." Within the EMU, budget deficits must stay below 3% of GDP, on pain of fines. At present, Germany, Italy and Spain are already near the 3% buffer and thus, may have to tighten policy heading into this downturn. In Spain, the current account deficit is presently 10%, with Greece sporting a current account deficit of 13%. To the north, Nordic countries sport current account surpluses setting the stage for a potential flash point within the EMU. According to a recent article in the London Daily Telegraph,
"Spanish Banks are issuing mortgage bonds to use as collateral at the ECB's window, without even trying to sell them on the open market. La Gaceta said this "abuse" has reached 40 Billion Euro's. As a result, the ECB has taken the political pulse of the Latin Countries in EMU, Spain, Italy, Greece, France etc... and concluded that rigor is now becoming too dangerous. It will face a hostile troika of Paris, Madrid and Rome if it persists, risking an EMU schism. Trumped by politics, the German Hawks have climbed down, the Euro must weaken, or it will break."
For the Euro, the key support over the next few days and weeks will be the all important 1.44 level. Over the last few sessions, the 50 day average has now turned down, giving the US Dollar a potentially overdue lease on life. In our article entitled, "Rotation, Rotation, Rotation" on Financial Sense dated 2/5/08, we noted that the US Dollar is historically oversold.
To this end, it would not be too surprising to see falling bond yields and a stronger Dollar team up against a falling Euro, falling stock markets and a correction in commodity markets in the medium to near term. Perhaps later on we would then see a mean reversion to a Dollar bear as long-term yields begin to rise.
While in Orlando recently for business, I had the pleasure of speaking at length with one of the top hedge fund managers in the world, and a fellow who was quite concerned about the near term outlook for European markets. At least in his view, the fact that the ECB has been so tight for so long would translate into a much sharper deceleration in earnings for European majors. To that end, his eye remains carefully focused on the mainstream European Indices such as the DAX, the CAC and the FTSE, which he expected could lead the US Stock Market in a breakdown to new lows. In all cases, the counter-trend rally action in these markets over the last 18 days has been exceptionally weak, with most of these indices tracing out large pennant formations. The implication from the pennant suggests downside continuation and new lows ahead. In literally all cases throughout Europe, economic data is moving into a sharp and sustained decline, something we imagine that the stock markets are only now beginning to factor in. In fact, looking around the world, even at the emerging markets, the picture now developing strongly points to a sizeable global slow down.
Last week, Ed Hyman, noted economist at ISI Group, pointed out that his ISI Developing Economic Economic Diffusion Index has now fallen from a late 2007 peak at a very robust reading north of 17% to a recent reading of just +3% making this downside reversal in Developing Countries the fastest reversal ever seen. Sounding off on the same subject, Morgan Stanley Chief Economist Stephen Roach stated,
"The acuteness of the pain the consumer is now enduring has laid to rest any argument that developing economies have decoupled with the United States. Evidence has mounted that developing economies are slowing as the spent up, lent up US consumer pulls back. The US Consumer is, by far, the biggest consumer in the world. Americans spent over $9.50 Trillion last year, whereas the Chinese consumer spent around 1 Trillion and Indian consumers spent around $650 Billion. The bottom line for the global economy according to Roach, -- when the US sneezes, the rest of the world can still catch a cold, -it makes no sense to preach the gospel of decoupling in an era of globalization."
Above: the German Dax Index.
Above: the Paris CAC – 40.
Above: London FTSE 100.
Finally, another aspect of the slow down in developing country economic growth has to be the potential impact on commodities. Yes, we know that commodities look like a one sided tree destined to grow to the sky without interruption. The very thought of a correction within commodity markets with Oil hitting $100 per barrel today sounds like sheer farce. Yet a close look at the CRB Spot Commodity Index shows the 9 week RSI above +90 last week, at a close of +91.27 last Friday. Can this stay here at these levels for any length of time? That is the question. From the weekly chart, it looks and acts very much like a blow off of some sort, with prices moving up and outside the upper end of the long term trend channel -- blow off action if ever there was such a thing.
Of course down the line, perhaps after a correction of real size, commodity prices will be back as we are convinced that major long-term themes such as Peak Oil and the population demographics of emerging China and India will pressure commodity supplies on many fronts. Yet, few markets move in a straight line indefinitely, and with Ed Hyman's Developing Economy diffusion index now plunging toward multi-year lows, one has to wonder when the hedge fund trade will reverse. To that end, our only answer to readers is keep an eye on the Yen, as the Yen Carry Trade has been, and likely remains the source of leverage capital for many a hedge fund manager. As can be shown in the charts below, whenever the Japanese Yen has rallied, hedge fund unwinding has commenced with deleveraging hurting the S&P and other markets such as Crude Oil.
Above: the Japanese Yen and the S&P 500, carry trade unwinding hurts the S&P.
Above: the Japanese Yen and Crude Oil, a rising Yen has also accompanied downside corrections in Oil and Gold.
At the moment, our technical work on the Yen suggests another low due in this time frame and a push to new highs near 95 or a spot rate near 1.05, then Par. This should mean that volatility will remain a fixture of daily life in all these markets with the equity markets the most treacherous game in town. The S&P ended at 1348.78, down 1.21 index points, with the DJIA finishing lower by -10.99 index points to end at a reading of 12,337.22. On the NASDAQ, prices also moved lower ending down by 15.11 index points to close at 2306.69, with stock prices falling as Crude Oil gained more then 4 dollars per barrel to close at $99.52. April Gold ended higher by $24.40 an ounce at $930.59, while the 10 Year Bond finished at a yield of 3.88%, up .10 basis points on the day. That's all for now,
© 2008 Frank Barbera